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Fed and Treasury Worked Against Each Other on Interest Rates

Rob Garver

In normal times, the Federal Reserve Board and the Federal Open Market Committee has pretty firm control over the level and direction of interest rates in the U.S., but the last few years have been anything but normal. When central bank policymakers pushed rates down to one quarter of one percent, bumping up against what economists call the “zero lower bound,” they had to resort to new methods of stimulating the economy.

The Fed settled on a policy of purchasing long-term Treasury and mortgage-backed securities in an effort to drive down the interest rates that those assets delivered. The idea was to make them less attractive to investors, who would then, in theory, find more productive places to put their money, hopefully creating jobs as they went.

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The Fed wound up purchasing well over $1 trillion in securities from 2008 on, in a program that is only just being wound down. But a new study from four Harvard economists, including former Treasury Secretary and head of the White House Council of Economic Advisers Larry Summers, found that the Treasury Department may have been making the Fed’s job much more difficult — and expensive.

The paper was presented Tuesday at the Brookings Institution’s Hutchins Center on Fiscal and Monetary Policy.

Summers and co-authors Robin Greenwood, Samuel Hanson, and Joshua Rudolph, analyzed the pattern of the Treasury Department’s regular sales of securities — basically the way the government borrows money to finance the federal deficit — and found that when it comes to interest rates, the Treasury was working directly against what the Fed was doing.

The Fed, by purchasing massive amounts of longer-term debt, drove up demand. By increasing demand, it raised the market price for purchasers of that debt, which translates into a lower interest rate paid by the debt issuer.

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At the same time the Fed was working to push rates down, the Treasury Department was pouring more and more long-term securities into the market. It did so partly to finance the growing federal deficit, but also as part of a conscious effort to increase the average maturity of the government’s outstanding debt.

This made sense from the federal government’s perspective — it locked in lower borrowing costs over a longer period of time — but the result, according to the authors, was that the two agencies were working at cross purposes. While the Fed was trying to keep money out of long-term securities in order to stimulate the economy, the Treasury was effectively doing the opposite.

“The Treasury’s actions have operated as a kind of reverse quantitative easing, replacing money-like short-term debt with longer-term debt,” they write.

With short-term interest rates at the zero lower bound, they say, the line between the Treasury’s tools and the Fed’s became unclear, resulting, by their calculations, in Treasury reducing the effectiveness of the Fed’s QE program by about 36 percent.

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The authors point out that, while the hope may be that the Fed never finds itself bumping up against the zero lower bound again, the possibility can’t be discounted. In such cases, the Fed and Treasury need to establish a means of working together to assure that they are not blunting each other’s efforts.

“This blurring of functions—and the observation that Federal Reserve and Treasury policies with regard to U.S. government debt have been pushing in opposite directions—suggests the need to reconsider the principles underlying government debt management policy,” they conclude.

However, Federal Reserve Board Member Jerome Powell on Tuesday said that he does not support the idea of Treasury and the Fed cooperating on policies regarding management of the federal debt. He argued that it would call into question the central bank’s independence from the executive branch.

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