The Fed Must Continue to Buy Government Debt

There was an article linked via Drudge about the U.S. Treasury having to pay off a record of over $7.5 trillion in maturing securities in fiscal year 2013 (October 2012 to September 2013).  Meanwhile, the article also states, the Treasury issued over $8.3 trillion in new securities during that same period.  The difference essentially makes up the accumulation of additional debt for the year.

Most Americans know little about how the Fed works and how the interchange works with the Treasury.  I find even many people knowledgeable about the Fed who do not really understand what happens.

The Fed increases the monetary base (creates inflation) by buying assets.  They essentially make up digits out of thin air.  The Fed can buy just about anything.  Prior to 2008, the Fed bought only U.S. government debt.  Since then, it has also bought mortgage securities, essentially bailing out banks with bad assets.

When the Fed buys, let's say, a 5 year Treasury note, then the Fed generally holds this asset for the full 5 years.  Meanwhile, the Treasury (the federal government) pays interest on this to the Fed.  After the 5 years is up, the Treasury note reaches maturity and the Treasury pays back the principal value of the note.

As a side note, the Fed pays back the interest it collects to the government, minus its operating expenses.  In other words, it is all an accounting game.

If the Fed held a Treasury note worth $1 billion, then allowing the note to mature and not taking any other action would actually be deflationary.  The Treasury would pay back the $1 billion and those digits would disappear, just the reverse of how the Fed created the digits 5 years before.

But in most cases, the debt will be rolled over.  In other words, the Fed would simply buy another 5 year note worth $1 billion.  The only thing that might be different is the interest rate.

So when the Fed is buying a lot of Treasury bills with a short maturity (a year of less), then this means that it will be rolling over a lot of debt.  This is why the figure of over $8.3 trillion is so large.

If you read one of the FOMC statements that comes out about every 6 weeks, you will see it stated that the Fed will continue to roll over maturing assets.  It says, "The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities and of rolling over maturing Treasury securities at auction."

When we hear about the Fed buying $85 billion per month in its "quantitative easing", this is a net amount above the rolling over of maturing securities.  So the Fed is actually buying far more than $85 billion per month in assets.  But much of this is just replacing what is expiring.  The $85 billion is the net amount being added to the Fed's balance sheet.

With this in mind, the Fed must essentially continue to buy government debt forever, as long as it is in existence.  The Fed is not going to pursue a highly deflationary policy of allowing maturing debt to expire without rolling it over.  We would be lucky at this point to see a policy where it simply renews maturing debt and doesn't buy any additional assets.  This would mean a stable monetary base, which would also mean a huge recession.  I don't think the Fed will pursue this policy for a long period of time until it is faced with the consequence of high price inflation.