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The Fed is unlikely to monetize the debt

Summary:
With the recent explosive growth in the Fed’s balance sheet, there’s been a lot of misleading discussion of the Fed “monetizing the debt”. Debt monetization occurs when a central bank prints high-powered money and uses the funds to buy interest-earning assets such as Treasury debt. In the US, high-powered money is currency (not bank reserves). The Fed does issue some new currency each year, but the revenue from this “seignorage” is small relative to the national debt (even with the recent spike in currency demand). Many people wrongly assume that issuance of bank reserves is another way of monetizing the debt. But using interest-earning bank reserves to buy back interest-earning Treasury debt is merely exchanging one government liability for another. You could get

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With the recent explosive growth in the Fed’s balance sheet, there’s been a lot of misleading discussion of the Fed “monetizing the debt”.

Debt monetization occurs when a central bank prints high-powered money and uses the funds to buy interest-earning assets such as Treasury debt. In the US, high-powered money is currency (not bank reserves). The Fed does issue some new currency each year, but the revenue from this “seignorage” is small relative to the national debt (even with the recent spike in currency demand).

Many people wrongly assume that issuance of bank reserves is another way of monetizing the debt. But using interest-earning bank reserves to buy back interest-earning Treasury debt is merely exchanging one government liability for another. You could get essentially the same impact by having the Treasury issue short-term T-bills and use the funds to buy back 30-year T-bonds. This action might be profitable, ex post, but then again it might also result in a loss. Either way, it’s clearly not debt monetization in the traditional sense of the term.

If the Fed targets inflation at 2%, then the stock of high-powered money is endogenous. In that case, the Fed basically has no control over the revenue from debt monetization. You might argue that the Fed doesn’t always hit its inflation target. But in recent years they’ve mostly been undershooting 2% inflation, which means they’ve done less debt monetization than is appropriate.

Indeed if you think the Fed’s 2% inflation target correctly represents the Congressional mandate of “stable prices”, then in a sense the Fed has been breaking the law by doing too little debt monetization. That’s hardly the impression one gets reading the newspapers these days.

Perhaps the Fed will eventually let inflation creep up to 3% or 4%. But even in that case the earnings from seignorage will be trivial relative to the national debt. Debt monetization is not an important issue in the US, and is not likely to be an issue going forward. The real problems lie elsewhere; there is too little NGDP growth, which contributes to high unemployment and financial stress. (Monetary policy is not the only factor right now, but it is a factor.)

Scott Sumner
Scott B. Sumner is Research Fellow at the Independent Institute, the Director of the Program on Monetary Policy at the Mercatus Center at George Mason University and an economist who teaches at Bentley University in Waltham, Massachusetts. His economics blog, The Money Illusion, popularized the idea of nominal GDP targeting, which says that the Fed should target nominal GDP—i.e., real GDP growth plus the rate of inflation—to better "induce the correct level of business investment". In May 2012, Chicago Fed President Charles L. Evans became the first sitting member of the Federal Open Market Committee (FOMC) to endorse the idea.

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