Is The Fed Increasingly Monetizing Government Debt?

 

By: Axel G. Merk, Merk Investments / GoldSeek.com

Fed Chair Bernanke vehemently denies Fed “monetizes the debt,” but our research shows the Fed may be increasingly doing so. We explain why and what the implications may be for the dollar, gold and currencies.

What is debt monetization? A central bank is said to monetize a government’s debt if it helps to finance its deficit. The buying of Treasuries by the Federal Reserve is a clear indication that the Fed is doing just that, except that Bernanke argues the motivation behind Treasury purchases is to help the economy, not the government.

The no-taper decision increased the Fed’s monetization of US debt. Gold may be more than insurance. Brace yourself for an escalation of Currency Wars.

To what extent does the Fed monetize the debt? The above chart shows that since the onset of the fall of 2008, the Fed has purchased enough Treasuries and Mortgage-Backed Securities (MBS), together, “quantitative easing” or (QE) to finance a substantial part of the government deficit. Indeed, by deciding not to “taper” off its purchases, the Fed is engaging in sufficient QE to purchase all debt issued and then some.

Shouldn’t one exclude MBS purchases in analyzing debt monetization? Buying MBS may provide the appearance that the Fed is not monetizing the debt when in fact it is. Don’t take our word for it, but the market’s: in a recent presentation to the CFA society in Melbourne, Merk Senior Economic Adviser and former St. Louis Fed President Bill Poole points out that the spread between 30-year fixed-rate mortgages and 10-year U.S. Treasury bonds have been virtually unchanged as a result of MBS purchases; from 1976 to 2006 the average spread was 1.74%. From May 2011 to April 2012 it averaged 1.76%. As such, the direct impact of QE on spreads has been extremely limited. If it sounds surprising, consider that investors have an array of choices that are highly similar: aside from currency risk, how different are German Treasuries versus U.S. Treasuries? Highly rated U.S. corporate issues versus U.S. Treasuries? They all have distinct risk profiles, but there’s a good reason why absent of issuer-specific news, these securities tend to trade in tandem. As such, the Fed is really just sipping with a straw from the ocean: setting rates may be more a result of communication (the “credibility of the Fed”) rather than the actual purchases.

If rates are set by words rather than action, doesn’t that prove the point the Fed is not monetizing the debt? We agree that talk is cheap. But talk doesn’t always move the market; as confidence in the Fed’s ability to control rates erodes, policy becomes ever more expensive: cutting rates, emergency rate cuts, Treasury purchases, Operation Twist, and moving to an explicit employment target are all escalations of a policy to “convince” the market to keep rates low. And along the way, the Fed has to spend more money. Ask the Fed, and they’ll tell you their operations are profitable. Clearly, as the Fed creates money out of thin air to buy income-generating fixed income securities, the more the Fed “prints”, the more profitable it is. Except that there’s no free lunch and pigs still can’t fly. By all means, no central bank in their right mind would start out with a policy to monetize debt. But as the chart above shows, the Fed now spends over 150% of government deficit to hold rates down, suggesting that its firing power is eroding. If and when we come to the stage that the Fed were to explicitly monetize the debt, it may need to buy a high multiple of what it currently does and might still fail to keep rates low. It’s a confidence game.

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