Will the Federal Reserve Monetize U.S. Government Debt?

Purchases of U.S. Treasury securities by the U.S. Federal Reserve in 2009 have prompted concerns that the Fed may monetize debt issued by the federal government, an act with potentially inflationary consequences. Whether such concerns are warranted depends in large part on the amount of Treasury securities the Fed purchases. So long as the Fed’s total ownership of Treasury securities does not exceed the amount of currency in circulation, the Federal Reserve will not be monetizing the federal government’s debt.Purchases of U.S. Treasury securities by the U.S. Federal Reserve in 2009 have prompted concerns that the Fed may monetize debt issued by the federal government, an act with potentially inflationary consequences. Debt monetization occurs when a government does not tax its citizens to repay the debt it incurs but instead prints money—or, in the modern equivalent, its central bank creates banking reserves by buying securities issued by its treasury department. The result is a larger amount of money chasing an unchanged amount of goods, which is a textbook explanation of inflation.Whether the concerns are warranted, however, depends in large part on the amount of Treasury securities the Federal Reserve purchases. So long as the Fed’s total ownership of Treasury securities does not exceed the amount of currency in circulation, the Federal Reserve will not be monetizing the federal government debt.The Fed’s ownership of Treasury securities is a form of seigniorage, which is the favorable difference between the cost of issuing currency and the face value of that currency. To function, an economy needs a certain amount of currency in circulation. The federal government can use the currency it issues to pay for government expenditures without having to raise that amount from taxpayers. So long as the government does not issue more currency than the economy needs to operate, inflation will not necessarily set in. The Fed’s purchases of Treasury securities amount to seigniorage because Treasury securities, which have an interest coupon and a maturity date, are effectively retired and replaced by currency, which is a form of non-interest-bearing government debt with no due date—or not really debt at all.Historically, a close correlation has existed between the amount of currency in circulation and the amount of Treasury securities owned by the Federal Reserve. But beginning in August 2007, the Fed substantially reduced its holdings of Treasury securities in order to offset the increase in reserves in the banking system resulting from its programs meant to support various sectors of the credit markets. Because the amount of Treasury securities that the Federal Reserve decided to buy in 2009 will not cause its total ownership of Treasury securities to exceed the amount of currency in circulation, the Fed will not be monetizing debt incurred by the U.S. federal government.