The Cap on Quantitative Easing

With the Fed buying $80 billion in treasuries over the past month, when is it time to hit the brakes on open market operations?

By Will Rojas

The U.S. currently maintains the second highest debt level relative to its economy (in terms of GDP)  in its history, second only to the year after World War II ended. The Congressional Budget Office estimates the federal deficit (or the difference between government expenditure and income) will be ranked similarly for the fiscal year 2020. However, by 2021 the relative size of its longstanding debt is primed to decrease on its own. This is possible because of low treasury yields.

The federal government is able to take on deficits because it issues treasury bonds, which supplement the capacity for government expenditures. However, the interest payments from issuing treasuries can take up a sizable portion of government expenditures if the debt levels or interest rates get too high. Because of this, the interest rates on treasury bonds are a critical factor in considering the sustainability of sovereign debt levels. Specifically, if the GDP growth rate is equal to or higher than treasury interest rates, debt will not grow as a percentage of GDP, and the same or lower debt level relative to the size of the economy can be maintained. However, it is unlikely many countries will experience this in 2020, given the crippling effect of the coronavirus on nations’ GDP’s. Despite this, Goldman Sachs predicts the U.S. GDP will grow by 6.2% in 2021, and since no treasury interest rate has risen above 3.5% since April of 2014 (and only on 30-year treasury bonds), it appears likely that federal debt taken into 2021 will decrease as a percentage of the economy so that if no debt is taken on in 2021, overall current federal debt levels will decrease relative to the economy. For this to be possible, The Federal Reserve will need to play its part in maintaining low interest rates on treasury bonds.

In late March, the Fed announced it would go beyond its initial plan to purchase $500 billion in treasuries and would continue to purchase them “in the amounts needed to support smooth market functioning,” pledging a seemingly unlimited dedication to treasury purchases. This helped keep treasury yields low because it lowers the supply of treasuries in the open market. The interest rate of a treasury bond is decided by an auction, and whoever bids to receive the lowest interest rate receives the bond. When the supply of treasuries drops, investors are willing to pay more for the bonds, meaning they are willing to receive less and bid for a lower interest rate in order to attain a treasury. On March 2, 2020 the yields—the effective interest rates at which bonds are being sold in the open market that serve as a benchmark for interest rates when the securities are issued—for 1, 2, and 3-month treasury bonds were 1.41%, 1.27%, and 1.13% respectively. By March 25, the Fed’s open market operations (or purchasing of treasury bonds) had helped reduce all three yields to 0%. If the Fed has the ability to decrease debt servicing costs to this extreme of a degree, what’s stopping it from doing it all the time?

There are legal and practical limitations to quantitative easing, or the practice of central banks to purchase securities in order to increase the money supply and maintain low yields on government-issued debt among other factors. The Federal Reserve currently maintains an ownership cap of 70% of any individual treasury security. However, this limit reflects a practical barrier to quantitative easing. For one, if the central bank purchases all of a security, it has no room with which to work anymore. This is especially important with government-issued debt, as treasury yields could skyrocket if the rates are dependent on quantitative easing and purchases suddenly stop. 

Since the Federal Reserve is legally blocked from purchasing treasury bonds directly from the Treasury Department, it relies on private holders such as large banks to provide them with the securities. This means that if the Fed has bought all available treasury securities on the open market, they cannot bid to receive new ones. When new treasuries are issued, there is an instant increase in the supply of treasuries on the open market and since the Fed cannot access them, whatever interest rate investors would bid after the Fed purchased the last treasury bond remains the same, and the Fed cannot lower that bid by purchasing treasuries as they have already purchased every one available. Yields will not only remain stagnant after this point, but inevitably jump as investors gain sole access to an infinitely larger supply of treasury bonds compared to the moment before the issuance. However, if the Fed had bought all available treasuries, yields would most likely be so low that the yield increase would not significantly harm the debt servicing cost of the federal government. 

Although it is unlikely government bond scarcity by itself would increase the cost of government debt, creating too much bond scarcity in too short a period of time could raise pressure on central banks’ finances. As central banks approach the point of buying all outlying government debt, the scarcity of the bonds increases and the yields continue to drop. This raises the price of bonds, and the more a central bank purchases government bonds while there is still outstanding debt issued from before it started a round of purchases, the more expensive that original debt grows to purchase. If enough quantitative easing with government debt occurs within a short enough period of time, the price of government bonds can spike and place a larger burden on the central bank. 

The Federal Reserve buys treasury bonds by crediting a bank’s account at the Fed equivalent to the value of the bonds it purchased. Banks can then choose to either keep those reserves and receive a special interest rate (IOER) on it or take the excess amount out of their account. An excess of credits deposited into banks’ accounts can lead to a large balance the Fed must pay interest on, a large increase in the money supply resulting from banks withdrawing from their accounts and making loans with it, or both. An increase in the balance on which the Fed must pay interest can be a problem if the amount paid in interest is greater than the amount received from treasury securities’ interest payments. The Fed can always lower the IOER rate it pays on excess reserves to lower this cost, but this would incentivize banks to withdraw their excess reserves. If banks choose to remove their excess reserves and lend it out, the money supply will increase and create an inflationary pressure. The Fed will either have to use other means to counter this or accept a higher inflation rate as a result of it. Even if there are enough treasuries left in the open market for the Fed to maintain low yields, buying them up too fast can result in higher inflationary pressures.

As governments around the world seek ways to finance emergency stimulus packages, they will turn to issuing debt. In order to keep the servicing costs on this debt low, many of the central banks will purchase the debt to maintain low yields, but they should be wary as the remaining debt grows increasingly scarce. □


Work Cited

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