For release: April 25, 2002
Contact: Charles B. Henderson, (314) 444-8311

Conducting Monetary Policy without Government Debt: A History Lesson from the Fed

ST. LOUIS -- If the recent declines in U.S. debt and the supply of Treasury securities resume, the Fed would have to rely more heavily on direct lending to depository institutions, or conduct open market operations in securities issued by other governments, federal agencies or even private concerns. This could expose the Fed to increased credit risk and possibly greater pressure to allocate credit, and the Fed's early history shows that effective monetary policy can be compromised by such pressure, said an economist with the Federal Reserve Bank of St. Louis.

The economist is David C. Wheelock, an assistant vice president at the Federal Reserve Bank of St. Louis. His comments appear in the May/June issue of Review, the bimonthly journal of business and economic issues published by the St. Louis Fed.

The Federal Reserve is the largest single owner of U.S. Treasury securities, excluding federal government accounts and trust funds such as Social Security and Medicare. Fed holdings of government securities are the principle source of the nation's currency and reserve balances at depository institutions--hence, the U.S. monetary base. The Fed, through its open market operations, buys and sells Treasury securities to either expand or contract the monetary base.

In the last several years, however, a substantial decline in the outstanding stock of Treasury debt has prompted some Federal Reserve officials to consider how the Fed might conduct monetary policy without a Treasury securities market.

"Treasury securities, especially Treasury bills, serve as liquid, risk-free investments and collateral for banks and other financial market participants," said Wheelock. "For the Fed, either a substantial increase in borrowing from its discount window, which typically is secured by loans and other private claims, or greater use of securities other than those issued by the U.S. Treasury in conducting open market operations, would expose the Fed to more credit risk than it faces today."

Monetary policy problems aside, Wheelock said that this exposure could complicate the Fed's other responsibilities as well. "For example, say the Fed became a major creditor to banks it supervises, rather than a lender of last resort," said Wheelock. "Consequently, any aggressive actions the Fed might take as a bank supervisor to deal with problem banks could increase the probability of losses by the Fed as a bank creditor."

For historical perspective and a potential parallel, Wheelock looked at the Federal Reserve's response to the infamous stock market crash of 1929. He found that the Fed did not respond aggressively to the sharp decline in economic activity that followed the crash nor the banking panics that occurred over the next three years. "One reason for the Fed's inaction," said Wheelock, "is that Federal Reserve officials remained mired in debate over whether the System should attempt to channel credit to 'appropriate' uses or pursue an active stabilization policy."

As that debate played out, Wheelock noted, many Fed officials were convinced that Federal Reserve credit should contract with declines in economic activity and loan demand. "Many of them argued that open market purchases during recessions in 1924 and 1927 had been a mistake and had contributed to the financial speculation that they saw as responsible for the subsequent economic depression," said Wheelock.

One result from those events was the expansion of the Federal Reserve's powers to influence the allocation of credit, including the authorization, under certain circumstances, to make loans to nonmember banks, groups of banks, and even to individuals, partnerships and corporations. As a result, Wheelock pointed out, Congress and succeeding Administrations have called upon the Fed, without success, to lend to distressed firms and governments, such as the Penn Central Corporation in 1970 and New York City in 1975.

"Arguably, if the Fed were to rely more heavily on discount window lending or to conduct open market operations in assets other than U.S. Treasury securities, the System could face could face intensified pressure to alter its asset portfolio," said Wheelock. "If the Fed's experience during the Great Depression is any guide, this desire to affect the allocation of credit--even one originating from within the Federal Reserve--has the potential to seriously undermine the independence of the Fed and the proper conduct of monetary policy."

Subscriptions to Review are available by calling (314) 444-8809.

With branches in Little Rock, Louisville and Memphis, the Federal Reserve Bank of St. Louis serves the Eighth Federal Reserve District, which includes all of Arkansas, eastern Missouri, southern Indiana, southern Illinois, western Kentucky, western Tennessee and northern Mississippi. In addition to serving as a bank for depository institutions and the U.S. government, each Reserve Bank monitors economic conditions in the District, participates in formulating monetary policy, and supervises state-chartered member banks and bank holding companies to foster safety and soundness of the District's banking and financial institutions and to protect the credit rights of consumers.

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