Monetary Realism

Understanding The Modern Monetary System…

Treasury and the Federal Reserve – Platinum/QE Integration

This is mostly for the potential benefit of Treasury and Federal Reserve operatives, in case they’re now seriously considering the operational implications of the platinum coin idea. I say this with tongue slightly in cheek, because both organizations obviously have highly qualified and brilliant experts in this area. This is just food for thought from an outside observer.

This platinum coin strategy has obviously been the subject of much recent public comment and debate. The platinum strategy more broadly is not the primary question for consideration in this post. The topic here is the potential for the specific operational integration of a platinum strategy with overall Federal Reserve balance sheet management.

Congress has the responsibility for approving spending and tax measures that Treasury implements through cash and funding management. Since spending and tax policy, once implemented, determine the budget deficit, Congress in effect approves the deficit that Treasury ends up incurring – before it incurs it. This interpretation naturally allows for the fact that there is an element of endogenous determination of that deficit due to uncertainties in overall performance of economy. But that doesn’t change the fact that Congress sets the policy dials for spending and taxation that together with economic performance end up determining the budget deficit.

The normal case is that Treasury must fund the resulting deficit with bills and bonds. And so, given Congressional authorization of spending and tax policy – and by implication the resulting deficit – Treasury depends on normally prescribed funding mechanisms using bill and bond issuance in order to implement policy instructions from Congress.

If Congress throws up a roadblock by impeding that normal funding process, it is reneging on what it has already authorized.

And that is the current situation regarding the debt ceiling. Treasury’s hands are tied in its responsibility to implement fiscal policy that has already been approved by Congress. If Congress refuses to increase the debt ceiling, Treasury will at some point be unable to fund the deficit in the way it normally does.

The possible scenario of a platinum coin solution to this operational impasse is generally understood by now. If Treasury deposits a platinum coin in its account at the Fed, the Fed will credit Treasury with funds and hold the coin as an asset. Treasury will use its funds according to what spending has already been approved by Congress, when taxes are insufficient to fund the required spending.

This operational adjustment can blend seamlessly with the Fed’s ongoing process of balance sheet management in the current economic environment. The coin is a relatively minor asset management tweak in this context. The Fed has an army of technical experts who can handle this adjustment within the constraint of overall policy consistency. That desired goal of policy consistency can be framed in the following way:

The essence of the quantitative easing concept (QE) is that it partially replaces the normal funding of the cumulative budget deficit – bills and bonds issued by Treasury – with bank reserves issued by the Fed. (The Fed also typically acquires bonds when it issues banknotes, but most of the ultimate funding for the cumulative budget deficit normally remains in the form of bills and bonds held by the public.) Currently, the Fed is operating a QE policy based on market purchases of Treasury and agency bonds in exchange for newly created bank reserves. At the same time, the Fed has been transparent in its intention to exit this strategy when the economy and the financial system gain firmer footing. The Fed will eventually eliminate the excess reserves it has created through asset sales and maturities. And it will be able to refine further the exit pace and the degree of associated monetary tightening by increasing the federal funds target rate and the interest rate paid on reserves. And it will also be able to tighten the immediate availability of bank reserves, if so desired, by auctioning off reserves as term deposit liabilities issued to the banking system. All of these elements point to a well thought out Fed contingency plan for the QE exit program. At present though, QE policy remains in full implementation mode.

The platinum proposal can be integrated with this plan in both the active QE implementation stage and the phase out or exit stage. If Treasury deposits a platinum coin with the Fed, the result will be a platinum asset held by the Fed and a deposit liability issued by the Fed to Treasury. Treasury will spend those newly created funds, and in that process Treasury balances will become bank reserve balances, still on the Fed’s books. The eventual result will be a platinum asset that is then funded by bank reserves. This is exactly the same funding result as occurs with regular bond QE.

In the context of its overall program for the QE related expansion of bank reserves, the Fed will now have two broad asset categories – Treasury and agency bonds; and platinum – funded by bank reserves created by each of bond QE and “platinum QE”. That augmented asset portfolio of bonds and platinum can be managed as part of a more broadly integrated QE strategy. The Fed strategy then consists of the optimal path over time for the size and composition of an augmented QE asset portfolio (bonds and platinum) held by the Fed, funded by bank reserves issued by the Fed.

In this regard, it should be recognized that the platinum component of this augmented asset portfolio is in effect a virtual QE bond portfolio. This is because platinum easing has replaced counterfactual (and normal) bond issuance – since the reason for the platinum asset on Fed books is that the Congress has not allowed bonds to be issued in the first place. In other words, the effect of platinum easing is very close to that in which bonds were issued instead and then purchased back in normal QE mode. Both techniques correspond to fewer bonds held by the public, compared to the relevant counterfactual without either bond QE or platinum QE. For this reason, the two modes of QE are directly comparable – not only in terms of the reserve funding effect, but in terms of the implication of the Fed’s asset portfolio for bonds outstanding and held by the public. Thus, the augmented QE program corresponds to a draining of bonds from the public sphere in two ways – purchasing bonds already issued (regular QE) and replacing bonds that should have been issued but that weren’t issued due to Congressional holdback of bond funding authority (platinum QE).

In both tranches of the augmented QE program, the cumulative budget deficit is being partially funded with reserves instead of bonds. In the case of regular QE it is technically a previously incurred deficit within the cumulative deficit that is being partially funded (re-financed) with reserves. In the case of platinum QE, it happens to be the current deficit that is being funded, which is effectively the front end of the cumulative deficit. Thus, in the case of platinum, the current deficit rolls out as Treasury spends its platinum sourced cash balances, creating new excess bank reserves as a result.

Finally, perhaps the most integrating characteristic of this augmented QE approach is that both regular QE and platinum QE tranches are intended to be temporary, and their prospective amortizations are captured within specified exit contingency plans. Regular QE begins to wind down and then reverse when the Fed decides enough is enough. Platinum QE begins to wind down and then reverse when Congress finally acknowledges its responsibility to permit the normal bond financing of spending that it has already approved. At that point, in both cases, the Fed and Treasury will work in concert to allow the Fed balance sheet to shrink and to replace bonds and platinum held by the Fed with bonds held by the public. In the case of regular QE, the Fed will either sell bonds to the public, or it will mature existing bonds that Treasury will refinance with the public. In the case of platinum, the Fed will return the platinum asset to Treasury and Treasury will fund the effective repurchase of that asset from the Fed by borrowing in the market. In both cases, there is an effective category conversion of Fed held bond and platinum assets to publicly held bond assets, with an accompanying withdrawal of excess reserves from the banking system.

The Fed can manage all of this on a fully integrated basis. As described, the augmented portfolio consisting of bonds and platinum is in effect a portfolio of actual and virtual bonds – because the same amount of bonds has been withdrawn from counterfactual public holdings – either by Fed purchase or by Congressional hold back. So the augmented portfolio is – in full effect – an actual/virtual bond portfolio. Thus, in this platinum easing context, platinum held by the Fed is equivalent to a bond in terms of its monetary policy effect. It is an effective operational monetary substitute for QE bonds – in the context of the problem now faced by Treasury in funding the budget deficit.

And because of this, the strategic management of the Fed’s balance sheet can become a seamless exercise in which platinum is simply a minor operational adjustment to current QE bond portfolio management by the Fed.  If the Fed begins to accept Treasury/Mint platinum on deposit, it is in effect accomplishing the equivalent of quantitative easing by buying bonds. And therefore, it can at its own option offset such platinum easing by adjusting downward the residual quantitative easing that it might have completed otherwise in the absence of the platinum modified strategy. And this sort of seamless strategic effect extends to the exit strategy. In the unlikely event that platinum easing proceeds long enough to interfere potentially with what might have been a more straightforward exit from the regular QE strategy, the Fed can simply step up the pace of exit on the bond tranche of the augmented portfolio. And again, the Fed has a rich array of tools in order to implement this exit strategy more comprehensively, including increasing the Fed funds rate and the interest rate paid on reserves. Moreover, a powerful tool that is sometimes overlooked is that at any point the Fed can proceed to auction off reserve balances as fixed deposits held by the banking system. This would have the intriguing effect of providing duration hedging product for banks in their own liability portfolio management process, and would also provide solace to some of those outside of the banking industry who (erroneously) believe that banks lend reserves when they make loans to non-bank customers.

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  • JKH

    The immediate mechanism:
    – rates go up on all floating rate bank assets – that includes prime rate lending; which is tightening
    – the anchor for the bank based yield curve increases, and its likely much of the curve will move to a higher level as well, reflecting what normally would be an expected tightening cycle that doesn’t stop with the first increase; which is tightening, and that ripples through all fixed interest rate markets and their pricing
    – wrt to reserves, you’re right that on that portion of bank balance sheets, margins may improve – because the liability rate structure will be slower to move off the zero bound; but in total the impact of rate moves on banks is complex and shouldn’t be oversimplifed

  • Sergei

    “It seems like QE has enabled us to transition to an IOR-based monetary policy system. Why not just continue with that?”

    Because, for instance, it would concentrate all interest expenses on the government deficit in the banks. Why should we prefer this outcome to the current one?

  • wh10

    I’m not sure, but it’s certainly not all. You don’t need to purchase every treasury to maintain an IOR system. The non-bank sector today still holds most of the treasuries.

  • Sergei

    “The non-bank sector today still holds most of the treasuries”

    Sure, but even with current excess reserves we already create big disturbances to the financial system. Look for instance how money market funds perform. I am not defending MMFs but I am curious to know why everybody seems so much fond of IOR and how easy it is for the Fed to exit. Simply increase IOR and bingo! I do not think it will be easy at all and I find IOR given ever increasing volume of excess reserves very disturbing. It is a big subsidy to banks which they most likely will not pass over and do not deserve to keep.

  • wh10

    What do you think about Canada’s system?

  • Sergei

    “What do you think about Canada’s system?”

    Sorry, I have no knowledge about Canadian banking system.