So Let Me Get This Straight

Let’s wander down the dark path of Federal Reserve monetary operations for a moment.

The Federal Reserve (Fed) creates and destroys money through its transactions with a set of Primary dealers. A primary dealer is a firm which has qualified under a set of guidelines to directly transact with the Federal Reserve (FED). The primary dealer agrees to purchase and sell Treasuries and other assets from and to the FED in order to accommodate FED monetary operations. Currently there are 24 U.S. primary dealers which include the likes of: J.P. Morgan Securities, Goldman Sachs & Co., Citigroup Global Markets . . . .

Federal Reserve monetary operations is the term used to describe FED operations which dictate short interest rates, and long term rates if the FED chooses to do so, which indirectly affects the money supply. When the FED wants to lower interest rates or increase the money supply the FED injects new money into the financial sector through the purchase of Treasury Securities and other assets from the primary dealers; when the FED wants to raise rates or shrink the money supply it sells securities to the primary dealers; this absorbs money out of the financial sector–all of which hopefully has some impact on the real economy.

Primary dealers sell and buy the securities with other private parties and they are central to the distribution of U.S. Treasuries. Primary dealers also buy Treasury securities during the Treasury Department’s initial sale of Treasury debt during Treasury debt auctions. The Federal Reserve Act prohibits the FED from direct purchase of Treasury debt from the Treasury Department.

Which is all very interesting, especially during the past dozen years or so. During 2006, prior to the financial crisis, the FED’s balance sheet contained roughly $850 billion in assets, about $750 billion of which were Treasury securities. During 2015, the FED’s assets approached $4.5 trillion, almost $2.5 trillion of which were Treasury securities and an additional $1.7 trillion of which were federal agency and government sponsored enterprise backed mortgage backed securities. As of November 2020, the FED’s balance sheet was roughly $7.2 trillion with $4.6 trillion in Treasury securities and over $2 trillion in federal agency and government sponsored enterprise backed mortgage backed securities. As you can see, with each crisis the FED accumulates more assets. The FED’s purchase of these assets is not only to target low interest rates, but also to provide liquidity to cash strapped financial firms who are threatened with the loss of their short term funding, due to the funding sources’ concerns that the financial firms’ portfolios will shrink in value and the firms will be unable to repay their short term loans. The name of the game is to borrow for short periods at low interest rates and then invest for longer periods where higher returns are attainable.

The FED can’t buy Treasury debt directly because, god forbid, this would give too much control of the money creation process to the public. The thinking in financial circles is that FED purchases and sales of Treasuries only in the open market, i.e., with private parties, allows greater FED independence; it enables the private sector to exert some level of discipline over the Federal government’s borrowing and spending. This is too bad. Earnings on Treasury securities held by the FED are returned to the Treasury Department, in other words the Treasury gets an interest-free loan on FED held Treasury securities.

The thing is, however, based on the above numbers, the FED, since 2006, has increased its Treasury holdings by $3.85 trillion. So the Treasury effectively sold $3.85 trillion into the private market which was then repurchased by the FED. You have two arms of government, the Fed and the Treasury, working together with a private sector actor, taking its cut, to facilitate the indirect transaction between the Treasury and the Fed. There are arguments, of course, as to why this is an efficient course of action, but some of us are not completely convinced, which brings us to the “let me get this straight moment”.

During both the financial crisis and now during the COVID-19 crisis, the FED has established Primary Dealer Credit Facilities (PDCF), backstopped by the Treasury, which enables the primary dealers to borrow funds from the FED in order to finance its securities holdings if market pressures make private sector funding unavailable. Stated differently, the FED loans money to the primary dealer, if market conditions dictate, guaranteed by the Treasury, so the primary dealer can buy Treasury debt from the Treasury and then sell it to the FED.

Pretty good gig if you can get it . . . .