Bernanke’s Fed Bills coming to a bank near you…How the Fed proposes to issue its own debt

EB's picture

Since October, 2009, the Federal Reserve has increasingly hyped the inflation meme by publicly touting the more than $1 trillion in excess reserves (held by banks with the Fed) which, as the theory goes, could come flying out into the economy in an HFT-New York second, in one hyperinflationary swoop.  If all the world’s a stage, then Bernanke will be winning an Oscar for this performance, because the futures and currency markets are pricing in a Fed rate hike in the second half of 2010 and a robust US economy.  Rather, we have postulated that this tightening theatre is mere preparation for QE 2.0, which has been confirmed today (at least with respect to more Agency MBS purchases by the Fed).  We suspect the Fed will wait until the US Dollar index rallies to at least 81 or 82 before announcing the next round of long term Treasury purchases.  Make no mistake, however, those pesky excess reserve dollars will eventually get itchy to rejoin their friends in the economy (perhaps when they amount to $3 trillion sometime in 2011), and the Fed will need all the tools it can strap around its bloated waist to reign them in. 

Through the Emergency Stabilization Act of 2009, passed shortly after the Lehman bankruptcy, Congress accelerated the effective date to October 1, 2008 of an amendment to the Federal Reserve Act that would give the Fed the authority to pay interest on excess reserves.  The pros and cons were best expressed by the manager of the world’s largest hedge fund (the FOMC’s System Open Market Account) in a speech on December 2, 2009 to the Money Marketeers of New York University:

A key part of the framework is the ability to pay interest on excess reserves. This authority alone may allow the FOMC to control short-term interest rates to its satisfaction, even if the banking system is saturated with a large amount of excess reserves. Indeed, the interest rate on excess reserves should act as a magnet for other short-term interest rates, keeping them relatively close together. In the current environment, the federal funds rate has remained modestly below the rate paid on reserves, typically by 10 to 15 basis points. If that spread were to remain steady near those levels even as the interest rate on excess reserves was increased, then policymakers would have sufficient control over short-term interest rates without the use of additional instruments. They could still choose a target level of the federal funds rate and could hit it by adjusting the interest rate on excess reserves.

However, policymakers face some uncertainty about how stable that spread will remain as short-term interest rates increase. The behavior of the spread today might not be that informative in this regard, as the proximity of short-term interest rates to the zero bound prevents the spread from getting much larger. In my view, the most likely outcome is that the spread will not widen substantially as short-term interest rates increase. However, if the spread does become large and variable, then policymakers will need other tools for strengthening their control of short-term interest rates.

With that in mind, monetary policymakers have asked the Federal Reserve staff to develop the ability to offer term deposits to depository institutions and to conduct reverse repos with other firms. These tools are similar in nature, as they both absorb excess reserves by replacing them with a term investment at the Fed. By removing reserves that would have otherwise been available for overnight lending, these tools could pull the federal funds rate and other short-term interest rates up toward the interest rate on excess reserves, providing the Fed with more effective control over the policy rate.

The development of both of these tools has made considerable progress…

We end there because the only sizable test of the triparty reverse repo system was perported to be an unmitigated disaster.  So, on the one hand, paying interest on excess reserves has worked so far, but may cease as short term interest spreads increase (and they undoubtedly will).  This could be solved by locking up reserves for a period of time a la reverse repos, but those do not appear to be doing the trick either (and with the all out assault on the money markets, it’s dubious they ever will).  Selling the Fed’s accumulated Treasury and Agency stash to drain reserves is completely out of the question as it would put a quick end to deficit spending and the housing refi bubble.  Enter the new Term Deposit Facility, but first, a bit of background.

Common knowledge holds that the Fed does not have authority to issue its own debt.  The very thought of the Fed competing with Treasury at auction does not seem kosher.  Yet, little more than a year ago, with a balance sheet that had recently exploded several orders of magnitude, the Fed was seriously contemplating the issue and exploring it publicly.  A WSJ article from December, 2008 had this to say:

The Federal Reserve is considering issuing its own debt for the first time, a move that would give the central bank additional flexibility as it tries to stabilize rocky financial markets.

Government debt issuance is largely the province of the Treasury Department, and the Fed already can print as much money as it wants. But as the credit crisis drags on and the economy suffers from recession, Fed officials are looking broadly for new financial tools.

The Federal Reserve drained $25 billion in temporary reserves from the banking system when it arranged overnight reverse repurchase agreements.

Fed officials have approached Congress about the concept, which could include issuing bills or some other form of debt, according to people familiar with the matter.

It isn't known whether these preliminary discussions will result in a formal proposal or Fed action. One hurdle: The Federal Reserve Act doesn't explicitly permit the Fed to issue notes beyond currency.

Just exploring the idea underscores many challenges the ongoing problems are creating for the Fed, as well as the lengths to which the central bank is going to come up with new ideas.

With Treasury-bill rates now near zero, it seems unlikely that Fed debt would push Treasury rates much higher, but it could some day become an issue.

There are also questions about the Fed's authority.

"I had always worked under the assumption that the Federal Reserve couldn't issue debt," said Vincent Reinhart, a former senior Fed staffer who is now an economist at the American Enterprise Institute. He says it is an action better suited to the Treasury Department, which has clear congressional authority to borrow on behalf of the government.

Even current high ranking Fed staff hold this to be true, as San Francisco Federal Reserve Bank President and CEO Janet Yellen stated on May 6, 2009:

The simplest approach—the one that we have used traditionally—would be to shrink our balance sheet by selling the Treasuries, agency debt, and agency MBS we accumulated during the crisis. Many of the special liquidity and credit facilities we have developed will be phased out as financial markets recover. But it is conceivable that, even with the economy rebounding nicely, the credit crunch might not be fully behind us and some financial markets might still need Fed support. In this case, we could increase the interest rate we pay on bank reserves. This would induce banks to remove funds from the federal funds market and lend them to us, thereby increasing the federal funds rate and longer-term interest rates that are more relevant to private borrowers. Importantly, this approach provides us with the flexibility to tighten monetary policy in response to an improving macroeconomic picture without shrinking the size of our balance sheet or our support to financial markets. It is the main method employed by many central banks to influence financial conditions. An alternative approach that could accomplish the same goal, and perhaps do it better, would be something completely new for the Federal Reserve—that’s to issue interest-bearing debt broadly to private investors. Let’s call this debt Fed bills. Congress would have to authorize this, but it too is a tool available to many central banks. The sale of Fed bills would reduce the reserves of the banking system, as in a typical contractionary open-market operation. As with interest on reserves, we could accomplish a tightening of policy while maintaining our support of credit markets. But Fed bills would have an advantage over interest on reserves. The loans to the Fed would come from investors throughout the economy, not just from banks.  [More on this later.] At a time when we need banks to lend to the private sector to fight a credit crunch, this is a decided plus.

Clearly, the Fed cannot issue its own debt.

However, on December 28, 2009, amid the eggnog-sloshed holidays, the Fed solicited comments on a proposed amendment to Regulation D that would combine the features of two of its other excess reserves handling facilities to create a new Term Deposit Facility (TDF).  As we will soon demonstrate, the innocuously sounding facility is nothing more than a de facto debt issuance mechanism that once again pushes the envelope of the Fed’s statutory (not to mention Constitutional) authority. 

And, lest we ask you to suspend disbelief any longer, consider the following.  If Treasury decided to become a bit more opportunistic and issued a new series of bills of multiple short term durations that (i) were auctioned competitively, (ii) paid interest, (iii) carried a zero risk weighting, (iv) were not directly transferrable, but (v) did allow for a temporary return of principal for a premium–would we not hesitate to call it a new debt instrument of the US Government?  That is exactly what the Federal Reserve will achieve with the TDF. 

So what of the fact that only banks can participate?  First, a developing story here is the filing for bank holding companies by hedge fund affiliates and private equity underwriters, which further blurs the line between banks and nonbanks.  Witness the recent grant of bank holding company status to Alcar, LLC, an affiliate of West Side Advisors.  Though the “conservative leverage of 2-3 times” was enough to bring down at least one hedge fund, one wonders what leverage will be employed with the ability to borrow at 0.12%.

Secondly, it is not difficult to imagine JPM setting up a new Fed Bills bespoke derivatives desk to overcome any transferability hurdles.  One of the interesting features of the Fed bills is that they may be used as collateral at the discount window so that, in a pinch, a bank could regain access to the supposedly locked up funds.  This is functionally no different than a bank pledging a T-Bill at the window; however, as we witnessed last fall, the hoarding and dumping of T-Bills made for some spectacular fluctuations in short term interest rates. 

The Fed is only statutorily bound in terms of the interest rate it pays, that it does not “exceed the general level of short-term interest rates.”  In the proposed Regulation D amendment, the Fed writes:

For these purposes, ‘‘short-term interest rates’’ would be defined as the primary credit rate and rates on obligations with maturities of up to one year in which eligible institutions may invest, such as rates on term Federal funds, term repurchase agreements, commercial paper, term Eurodollar deposits, and other [Treasury? No don’t mention Treasury] similar rates. 

Conceivably, even an average over several weeks would do.  What premium or discount would Fed Bills command with respect to Treasury Bills?  With hundreds of billions (or trillions) in excess reserves locked up in durations of up to one year, would the Fed not have the ability to directly influence a broader spectrum of the yield curve?  Once Treasury QE 2.0 is announced, would the Fed not be the entire yield curve?  Consider too, it would take but a one sentence revision in a ramrodded Congressional bill circa the next crisis to allow the Fed to pay interest at any rate, thus introducing Fed Notes and Fed Bonds.

No doubt, the Fed has considered this, but there is no precedent for the actions of the world’s largest central bank engaging in these types of activities.  By President Yellen’s own admission, the Fed did not have the authority to issue its own debt in May, 2009, so why does it now?  A simple question posed, but unlikely to get a response, just prior to Mr. Bernanke’s reappointment vote.

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californiagirl's picture

Hmmm... Does this have something to do with the "Group of Thirty" and SEC proposals to turn money markets into illiquid hedge funds?  If Banks' excess reserves decline (e.g. due to looming commercial real estate debt debaucle or continued writedown of other bank assets and bad mortgages), won't the banks need to move money from their "excess" funds parked at the FED to their actual reserves?  Then the FED has to raise money to give it back to the banks.  Or, can they work on another change in the law to reduce the required reserves or allow a portion of those reserves to remain at the FED instead of the bank's own vaults.  After all, why have so much money sitting at the banks if money markets can be frozen and bank customers can be denied withdrawal of their funds?

Anonymous's picture

So they do this and GS et al will just gun the stock market into the ionosphere on the back of cheap funds. Again, Mr Bernanke, this solves problems in the real economy how exactly?

Why don't they just cut the crap, forget this trickle down garbage and just deposit money straight into citizens' bank accounts in a non-biased way, that they just printed out of thin air, and be done with it?

Anonymous's picture

Do not pass Go, do not collect $200.

Your currency is being replaced (queue bitch slap across the face of all US citizens).

Mabe next time the US treasury gets raped you won't turn a blind eye and look away like the cowards you are.

Anonymous's picture

What do you mean the Fed doesn't issue its own debt?

It always has done, the dollar is a Federal Reserve Note (note the NOTE). It is just (supposedly) the more marketable form of the bond the Fed holds as the asset to back its NOTE issue.

When the Fed repos (& buys outright) government and increasingly, private bonds it is creating 'deposits', that is, borrowing 'money'. These deposits can then be withdrawn by the 'depositors' as Federal Reserve Notes. The trouble is bonds are not really money at all, they are obligations to pay money.

So, the Fed is really borrowing obligations, turning it into dollars which are then passed off as money by government decree.

Anonymous's picture

-1. FED is collecting interest for its services at the rate it calls the "discount". The income so collected is further free of any levies, taxes and such. The "note" is a tender for "all debts, private and public". FED is debt free, ad perpetuum.

Anonymous's picture

I think I will issue my own notes to pay my taxes with. Farging Bastages.

Anonymous's picture

In short and in summation, get your money the hell out of everything.

Anonymous's picture

What the hell do you mean, "your money?"

It all belongs to the masters that crashed everything. It was never yours, nor will it be, even if it's taken out - welcome, surf.

Doesn't reckless boomer entitlement mean anything anymore?

cocoablini's picture

I just issued 300 billion in zero interest notes. See- it's that easy. Come and get it folks

Anonymous's picture

I do not see any problem with the Fed issuing its own debt. The Fed is a privately owned company and should be able to issue debt as any other privately owned company. It may look funny to many people when the Fed buys Treasuries since it looks like the Federal government buys its own debt. Actually, a private company buys the Government debt. It owns all of the US since the US bankrupted in 1913.

jm's picture

Aside from the legal issues. The problem is that that if their asset returns don't meet cost of operation, they have to print money to cover.   

Avoiding such money printing was precisely the motivation for having an independent monetary authority in the first place.


Anonymous's picture

With the potential lock up of money market funds, due to their toxic contents and treasuries, which will be agonizing to those who do not get the message, this is just icing on the cake.

The Fed and the Treasury both selling debt, and the Fed has the banking business locked up. How does that play out in the world of unintended consequences?

We will have big ads on TV offering AAA safe investment in both bankrupt entities. Can't wait to send in my money.

Some one needs to pull the stop lever on these deranged clowns and their means of theft. In my Econ 101 class the prof offered this pearl " don't ever loan money to the bankrupt because for some reason you will never see it again." That seems to still ring true, especially in the many ringed ponzi circus that we now live in.

I think this hyper complicated stuff is concocked to hook the arrogant who would never admit that they do not understand it a bit. It was never made to be understood. But it sounds so good in the promotion.

Matt Tabbi your mission if you choose to accept it ...

Quantitative Wheezing's picture

Just figure money center banks will purchased treasuries until 40% of assets are held in treasuries.  This may take a decade but that's where we are headed.  Treasuries will be supported by the massive cash held on reserve....

Charles Mackay's picture

Effectively it does not really make much difference to QE2 if the Fed issues its own notes, or if the Fed just has its own term CDs for banks.  Some in the Fed have already said the latter is legal.

Alternatively the Fed could bypass this plan altogther, since it appears that Fannie and Freddie will need to borrow huge sums from the Treasury.  To help finance the Treasury, the Fed could directly lend them money under some type of 'supplemental finance program'.  If that doesn't work, banks could buy the SFP bills, and then repo them back to the Fed under some other type of new program.

The bottom line is that one way or another the Fed is going to create or buy some notes/bills and the Treasury is going to seek out a way to finance the extra agency debt.

The only question remaining is - when will QE2 start?


Assetman's picture

The only question remaining is - when will QE2 start?

QE2 will start when there is enough underlying demand to issue a new wave of Treasuries at very low cost.

An engineered global flight to quality would certainly be timely sometime this year, now wouldn't it?

EB's picture

I agree. The point was to point out the hypocrisy. Another avenue is for the Fed to put the $4.4 billion in intragovernmental treasury holdings on its books through a permaroll term facility. The agencies would then purchase a corresponding amount of on the run treasuries.

Charles Mackay's picture

I agree but I think that would require a federal law, being because there actually is already a federal law allowing the Treasury Department to threat the intra-governmental treasury holdings of the huge Thrift Savings Plan as 'money' which can be borrowed by the Treasury - and in return they issue the TSP an IOU.

However I would not put it past the Fed to put a plan like this through with only the flimsiest legal cover.


Orly's picture

Is it just me, or can I barely read this?

SimpleSimon's picture

Finally, I could read something I could understand in a HFT moment -your comment.  The rest of the article jogs the fogs of this Balvenied mind but needs some more neat shots before I can attempt again.

But where is the Fed paying interest from?  By printing more money?  Isn't that another transfer of wealth to their masters on Wall Street by devaluing the dollar?

A_MacLaren's picture

" But where is the Fed paying interest from?  By printing more money? "

Possibly.  The Fed does hold significant quantities of Treasuries and Trashuries (Fannie/Freddie MBS).  These instruments (I hesitate to call these debt obligations "assets") pay interest to the Fed, while the required and excess reserves and currency are the Fed's liabilities. 

The currency is a zero interest note (FRN's) and so there must be significant cash inflow from the other investment instruments.  The Fed would merely divert some of the seniorage otherwise payable to the Treasury on the priveledge of issuing currency and divert it to the Banksters.

Hmmm....   Another way to enrich the owners of the privately held Federal Reserve at the expense of the Debt Slaves, I mean the citizens...


spanish inquisition's picture

So if the Fed is printing money to pay interest, it technically is not going to the Treasury first. Which means the Fed can print money and give it to anybody or any country? I can see why they don't want to be audited.

I am probably over extrapolating here, but it kind of makes sense or I am really drunk.

edit- is there anything that says the Feds only customer is the Treasury?

Anonymous's picture

The Feds only customer is anyone that doesn't make over $250,000 a year.

Did you think it had anything to do with the common man? Sucker.

Orly's picture

So sorry, SimpleSimon.  You must have me confused with Chauncey Gardner.

I was referring to the small type.  I can barely read this.



jm's picture

This is a lot to chew on.  The continued nominal GDP contraction assures no hope for a rational exit strategy.

Fed notes could very well be the last straw before the rest of the world says to hell with the current system and takes their chances.

knukles's picture

Zero Coupon Perpetual Debt is on offer by the FED 24/7. 

Called dollars; liability, pays no interest, never matures. 

Whaddyamean they don't issue debt?  Wake up! 

Anonymous's picture

If you dont want these dollars that you imply are worthless please feel free to send them over to me. Thanks in advance.

MarketTruth's picture

Will gladly send you modern Federal Reserve Notes (dollars) in exchange for other USA currency/legal tender. As such, for every 1 ounce Gold American Eagle coin as produced by the United States Mint i shall send you the face value of $50 plus an additional $50, so you are effectively doubling your 'money'. For every Silver American Eagle as issued by the United States Mint i shall send you $5, effective giving you 5x the face value of said USA legal currency. If you agree, please e-mail me. Thank you.