Wednesday, June 3, 2009

Bernanke: Fed Has No Plans to Monetize Debt

Federal Reserve Chairman Ben Bernanke today told Congress that the central bank has no plans to monetize the sharply rising deficits of the United States and defended the Fed's program to purchase Treasuries. He told Congress of the need for Washington to control spending and set appropriate tax levels, in consultation with the American people, to achieve 'fiscal sustainability' in the long term. By that he meant a situation where the ratio of government debt service to the size of the economy is stable or declining.

By Robert Stowe England

June 3, 2009

In his appearance before Congress today Federal Reserve Board Chairman Ben Bernanke responded directly to mounting worries about sharply rising budget deficits in the United States, amid growing concern among major international investors in U.S. Treasuries, from China to Saudi Arabia, that the Fed might monetize those deficits.

If the Fed were to monetize the debt issued to cover most of the rising deficits, it could lead to inflation and potentially sharp losses in the value of the dollar and, thus, the value of investments in U.S. Treasuries.

In response to a question on monetizing debt, Bernanke stated: "The Federal Reserve will not monetize its debt."

Bernanke further defended the Fed's plans to buy $300 billion in Treasuries on April 3. "I think it's important to point out that notwithstanding our purchase of Treasuries as part of a program to strengthen private credit markets, even when we complete the $300 billion purchase that we have committed to, we will still hold less Treasuries, a smaller volume of Treasuries, than we had before the crisis began."

Through the Fed's open market program it is frequently a market player that purchases or sells Treasuries to achieve interest rate targets for the Federal funds rate.

Bernanke did not address growing speculation that the Fed will expand its $300 billion Treasury purchase program, which might have the opposite effect intended and lead to higher Treasury and mortgage rates. Low mortgage rates, in particular are critical to the recovery in the housing market, a strategy at the heart of revitalizing the financial sector of the economy.

Government debt is monetized when Treasuries are purchased by the central bank (the Federal Reserve). Or, put more simply, central banks monetize debt by printing more money.

For a more detailed discussion of monetizing debt see article by the St. Louis Fed at this link: http://research.stlouisfed.org/publications/review/84/12/Monetizing_Dec1984.pdf

In recent weeks rising Treasury and mortgage rates have raised fears of inflation and rattled the financial markets. The yields on 10-year Treasury notes, for example, have risen from 2.5 percent in March to 3.7 percent on June 1.

There has been a corresponding increase in mortgage rates, leading to a decline in mortgage originations, which previously had been booming. Today the Mortgage Bankers Association announced that the average contract interest rate for 30-year fixed-rate mortgages increased last week to 5.25 percent, a steep rise from 4.81 percent in the prior week.

These interest rate hikes have occurred even though the Fed has been purchasing new issues of Treasuries and mortgage-backed securities, which were intended in part to keep down rates at a lower level than they might otherwise be.

Bernanke gave his own explanation for why rates have risen. "These increases appear to reflect concerns about large federal deficits but also other causes, including greater optimism about the economic outlook, a reversal of flight-to-quality flows, and technical factors related to the hedging of mortgage holdings."

Bernanke was referring, in part, to the fact that in the months following the global financial meltdown and freeze-up of credit markets that began in September after the failure of Lehman Brothers, funds flowed into U.S. Treasuries as a safe haven in a flight to quality. As markets have begun to function better and spreads come down, some of the money that flowed in to U.S. Treasuries has flowed out.

In his remarks, the Fed Chairman summarized the deteriorating fiscal situation and the worsening outlook for even higher levels of debt.

"The Administration recently submitted a proposed budget that projects the federal deficit to reach about $1.8 trillion this fiscal year before declining to $1.3 trillion in 2010 and roughly $900 billion in 2011," Bernanke stated.

"As a consequence of this elevated level of borrowing, the ratio of federal debt held by the public to nominal GDP is likely to move up from about 40 percent before the onset of the financial crisis to about 70 percent in 2011," Bernanke testified.

"These developments would leave the debt-to-GDP ratio at its highest level since the early 1950s, the years following the massive debt buildup during World War II," he added.

Bernanke also spoke about expected huge increases in Social Security and Medicare spending as baby boomers retire. He cited the projections from recent trustees reports that outlays on these two programs will increase from 8.5 percent of the gross domestic product today to 10 percent in 2020 and 12.5 percent in 2030.

As well, Bernanke defended the Fed against charges that its plan to purchase $300 billion in Treasuries represents an effort to monetize the debt.

Bernanke described the Fed's plan to buy up to $1.75 trillion in assets April 3 and place them on the Fed's balance. The plan to purchase $300 billion in Treasuries was on the list of assets. At the time, the Fed had $490 billion in Treasuries on its balance sheet, Bernanke said.

In addition to the $300 billion in Treasuries, the Fed is committed to buying $1.25 trillion in mortgage-backed securities issued by Fannie Mae and Freddie Mac, as well as $200 billion in debt issue by the same two government-sponsored entities.

"The principal goal of these programs is to lower the cost and improve the availability of credit for households and businesses," Bernanke said. His expalanation of the expanded Fed balance sheet can be found at this link: http://www.federalreserve.gov/newsevents/speech/bernanke20090403a.htm

On January 13 Bernanke also defended the asset purchases as part of a "credit easing" program, which he differentiated from "quantitative easing."

"Our approach -- which could be described as 'credit easing' -- resembles quantitative easing in one respect. It involves an expansion of the central bank's balance sheet. However, in a pure QE regime, the focus of policy is the quantity of bank reserves, which are liabilities of the central bank; the composition of loans and securities on the asset side of the central bank's balance sheet is incidental," he said.

Bernanke's January 13 comments at the London School of Economics can be found at this link: http://www.federalreserve.gov/newsevents/speech/bernanke20090113a.htm

Even so, since early April the Fed's policy of purchasing $300 billion in Treasuries and other assets has been described by some as quantitative easing.

Criticisms of the Fed's $1.75 trillion program to intervene to improve the availability and cost of credit have risen in recent weeks.

German Chancellor Angela Merkel only yesterday rebuked central banks in the West for going too far in fighting the financial crisis.

Viewing "with great skepticism the powers of the Fed," the European Central Bank and the Bank of England, she called for policy restraint in a speech in Berlin. "We must return together to an independent central-bank policy and to a policy of reason. Otherwise, we will be in exactly the same situation in ten year's time."

Bernanke, in defense of the Fed, pointed to some of the successes of its programs:

An improvement in short-term funding, including the interbank lending markets and the commercial paper market. "Risk spreads in those markets appear to have moderated, and more lending is taking place at longer maturities," Bernanke testified. "The better performance of short-term funding markets in part reflects the support afforded by Federal Reserve lending programs."

A pick-up in the issuance of asset-backed securities (ABS) backed by credit card, auto, and student loans and a decline in ABS funding rates. Both of these developments have been "supported by the availability of the Federal Reserve’s Term Asset-Backed Securities Loan Facility as a market backstop," he stated

Relatively strong issuance of long-term bonds by nonfinancial firms and a narrowing of spreads between Treasury yields and the rates paid by corporate borrowers.

Echoing themes that former Fed Chairman Alan Greenspan used to sound in his testimony, Bernanke briefly made his case for fiscal responsibility.

"Addressing the country's fiscal problems will require a willingness to make difficult choices," he said.

Striking a politically neutral note, Bernanke stated, "In the end, the fundamental decision that the Congress, the Administration, and the American people must confront is how large a share of the nation's economic resources to devote to federal government programs, including entitlement programs."

Bernanke's message on taxes was two-fold. First, he was open to the idea of higher taxes with these comments: "Crucially, whatever size of government is chosen, tax rates must ultimately be set at a level sufficient to achieve an appropriate balance of spending and revenues in the long run."

Yet, he warned that if tax rates are raised too high, it can be counter-productive."In particular, over the longer term, achieving fiscal sustainability--defined, for example, as a situation in which the ratios of government debt and interest payments to GDP are stable or declining, and tax rates are not so high as to impede economic growth--requires that spending and budget deficits be well controlled," he stated.

In closing his prepared comments, Bernanke promised to enhance the transparency of the Fed's credit and liquidity programs.

Bernanke's prepared remarks can be read at this link: http://www.federalreserve.gov/newsevents/testimony/bernanke20090603a.htm



Copyright 2009© by Robert Stowe England

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