Bank Policy Institute: When the Fed Buys a Treasury Security, the Debt Does Not Go Away

hen the Fed buys a Treasury security, the debt does not go away. The Treasury security is a borrowing by the Treasury from an investor in exchange for a promise to repay the funds, plus interest, as scheduled. When the Fed buys the Treasury security, it is transformed into deposits of a depository institution at the Federal Reserve, also known as “reserve balances.” A deposit at the Federal Reserve, in turn, is a borrowing by the Fed from a depository institution (commercial bank, thrift or credit union) in exchange for a promise to repay the funds, plus interest, on demand. The Fed’s assets go up by the amount of the purchased security and its liabilities go up by the increase in reserve balances. The consolidated borrowing of the U.S. government, including the Fed, is unchanged.

Although the total consolidated amount of Federal debt does not change, there are two important differences between these types of borrowings. First, anybody can own a Treasury security, but only a depository institution (henceforth “bank”) and a few government agencies can have a deposit at the Fed. As shown below, this means that when the Fed buys the security, the reserve balances created can crowd out other bank assets, including bank lending. Second, Treasury securities are often long-term borrowings while deposits at the Fed are ultra-short-term borrowings (they are payable on demand). The maturity mismatch leaves the Fed, like a similarly situated bank, subject to significant losses if interest rates rise unexpectedly. Not only that, but the Fed will lose money even if everything evolves exactly as expected because term premiums are currently estimated to be negative.

The full article is available at https://bpi.com/when-the-fed-buys-a-treasury-security-the-debt-does-not-go-away/

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