Peter Stella on the Quasi-Fiscal Implications of Central Bank Crisis Intervention

Transferring liabilities from the Fed to the Treasury is one way the US could more effectively manage central bank debt during times of crises.

Peter Stella is the former head of the IMF’s Central Banking Division and has researched and written extensively on safe assets, collateral, and central bank operations. He now hosts the website, Central Banking Archaeology and continues to consult with the IMF on central bank balance sheet issues. Peter is also a returning guest to the podcast, and he rejoins Macro Musings to talk about the quasi-fiscal implications of central bank crisis intervention over the past few years. David and Peter also discuss the losses on the Fed’s balance sheet, using market value versus the par value of debt, the Fed’s debt management issues with mortgage backed securities, and more.

Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].

David Beckworth: Peter, welcome back to the show.

Peter Stella: Thank you, David. It's great to be back and it's great to be back in person after COVID.

Beckworth: Yes. So it's been great to have you on. I've learned a lot from you about central bank balance sheets. In fact, I remember when I first read your work before I actually had met you, I read a paper by you about losses on central bank balance sheets or capital positions or equity positions on central bank balance sheets. You'd done a historical look back and how important was it, and lo and behold, here we are in 2023 and this has become a very topical issue again, given all the big interventions central banks did during the pandemic. As you know Peter, and we're going to talk about the paper that you've written, there's been some big losses on the Fed's balance sheet, some unrealized losses. There's some actual net income losses as well. Other places like Switzerland, Swiss National Bank, even bigger losses is my understanding, if that's correct.

Beckworth: So central banks are beginning to see some of the consequences of expanding their balance sheets rapidly during the pandemic. And you've written several articles on this. I'm delighted to have you here for this very reason. You've written several articles based on your many years of experience thinking about this. So first you have a paper that's titled, *Should the Fed Have Lost $1 Trillion?* And we'll come to that in a minute. You also have two IMF papers you co-authored. One is titled, *Quasi-Fiscal Implications of Central Bank Crisis Interventions,* and secondly, *Quasi-Fiscal Implications of Central Bank Crisis Interventions: Case Studies.* And in that second one, you look at Canada, Chile, United Kingdom, the USA.

Beckworth: So you go around, do a case study, but you talk extensively about some of these issues. So let me start off with this. You did this for a living for many decades. You went to emerging markets, developing countries. I remember you telling me a story, Peter, where you went to Chile and they had, half of the debt market was central bank securities. The other half was Ministry of Finance securities. So you've dealt with large balance sheet issues before. Did you ever think it would come home to the US and to advanced economies to the scale that it has over the past few years?

Stella: No, certainly not. And I'll tell a little story. In 1997, I wrote this paper, *Do Central Banks Need Capital?*, which maybe wasn't that popular at the IMF, but it was a provocative title. And someone reached out to me from the US, Marvin Goodfriend, the late Marvin Goodfriend, and he shared some of his work along similar lines, but shout out to the late Marvin Goodfriend. He was certainly the only person in the US or the, let's call it the developed world, I hesitate to call it the advanced world, but the developed world, that latched onto this work I had been doing and thought it was important. So certainly it was very important in the emerging markets, Latin America and Asia. But in these other countries, sometimes people, even in my own division would give me this cross eyed look like, what are you talking about? Do central banks have a balance sheet?

Beckworth: And now it’s come home to roost in the US of A and in Europe. And I'm not sure what's happening in Japan on its balance sheet. Is it also experiencing losses?

Stella: I'm not sure, but I know Canada is now showing a capital deficiency. Australia has a very big negative equity position.

Beckworth: So it's pervasive at the moment.

Stella: Yes.

Beckworth: Yes. It's all around the world. So this move towards bigger balance sheets at central banks has definitely come with some costs that maybe we didn't fully appreciate beforehand. I know Claudio Borio recently had a speech where he brought this issue up and he brought it up in the context of, maybe the ample reserve system operating system isn't all that we thought it would be. Maybe we need to rethink these issues, think through the fiscal costs that have become very clear now that we've come into it. So let me begin our conversation on your papers with the one about the Federal Reserve, and then we'll move to the IMF. And I wanted to start with the one on the Federal Reserve, which is titled, *Should the Fed Have Lost $1 Trillion?*, because you do a number of interesting things in there. First you break down the Fed's income into what you call an orthodox net income stream, and then a heterodox net income stream. We'll come back to those in a minute. But you go through and you talk about losses on the Fed's balance sheet, and it matters whether there are losses… these unrealized losses, if there are losses on Treasuries versus mortgage backed securities. So maybe walk us through this distinction and why it matters.

Fed Balance Sheet Losses: Treasuries vs. MBS

Stella: Okay, so let me start out, for some of the listeners who might not know, I have been fighting an insurgency against using all of the different policy measures that central banks have taken over the last 15 years and putting them all under the appellation QE. So this is very, very frustrating to someone who believes and knows that the design of policy is very, very important. While I was waiting to come into the studio, I read a little quote from Friedrich Hayek in the room that says, an economist’s job is to tell people how little they are able to model policy interventions. And I'm not quite in line with that. I'm basically saying that what was nice about the IMF work was you got to see different countries did things differently and there were some pluses and some minuses almost always. And to put them all under one rubric is very, very frustrating because you can't really talk about these differences if everyone is convinced they were all the same.

Stella: And to me it's like, maybe this is an apocryphal story, but there’s this anthropological notion that the indigenous people of the Arctic had 20 words for snow. And of course for them it's very, very important to describe what snow they're dealing with, their life can depend on making these distinctions. So imagine if you force them to say, no, no, no, you can't use 20 words, you need to use one word, only one word. This would be extremely frustrating and extremely dangerous to treat them all as the same way. So that's why I'm so frustrated with QE being used to describe so many different policies that really have differences. And the one we will focus in on today is it matters whether you're buying government securities or private securities, mortgage backed securities. And by the way, it's happening now with QT, right?

Stella: So my frustration is being doubled now even though New Zealand, the UK, the US are all exiting in importantly different ways. Everyone's saying, no, it's just QE. So that's my insurgency, which will no doubt fail, but many famous historical revolutions have been viewed as highly unlikely at the beginning and wound up being important. But Ben Bernanke, when he was at the Fed, I don't think ever used the term QE. You remember he described what the Fed was doing as credit easing. Now he is using the term QE, so coming back to the question about the Fed's balance sheet, so why are these policies different? Well, in the first case, and just to give you the numbers. So in 2022, the unrealized losses of the Federal Reserve on its securities portfolio rose by 1.2 trillion.

Beckworth: That's huge.

Stella: $800 billion on the US Treasury portfolio and $400 billion on the MBS portfolio. Now, if you start with the unrealized loss on the Treasury portfolio, you could say, and it's correct to say, the Fed's loss is identical to the Treasury's gain. So the present discounted of value of the payments that the Fed is going to receive from the Treasury have gone down by $800 billion. The expected present discounted of value on the debt obligations of the Treasury to the Fed have gone down by $800 billion. So, I'll explain why we care in a minute. Now, in the case with the mortgage backed securities, the present discounted value of the expected payments on the mortgage backed securities the Fed is holding fell by $400 billion in 2022. Okay, so who's the gainer on that side? Well, it's everyone who took out a mortgage at historically low interest rates during COVID, and now their house prices have gone up. This house inflation, price inflation, the real present discounted value of the mortgage payments has dramatically fallen. So it's a difference. So someone in the economy has made a gain against the Fed's loss.

Beckworth: That's me. I'm one of those people.

Stella: Yeah, well, good for you. But someone has made a loss on the other side of that.

Beckworth: Right. And the taxpayers ultimately are bearing that that loss on the Fed’s side. And you also note in your paper too, not everyone was fortunate enough to refinance at low interest rates and take advantage of this opportunity. Many people who rent, they've been priced out of markets. So there's a lot of issues going on there. Let me go back to your first observation about the $800 billion unrealized loss on the Fed's balance sheet is offset by the gain for the Treasury in terms of a lower debt liability going forward. Now, how would you measure that? Because I wrote a piece recently in Barron's, and I've talked about it on the show before with George Hall, but I used a measure of the market value of Treasury debt versus the par value; par value being the face value, market value being what's actually traded on the marketplace. And I used market value as a percent of GDP. So that's a pretty standard debt to GDP ratio. A lot of places though, like the IMF, World Bank, most places will use just regular par value over GDP. I used market value because I saw some other smart people do it. It made sense to me intuitively. I got so much pushback, Peter, but when I read your article, I felt validated. So walk us through why it makes sense to use market value.

Using the Market Value of Debt Instead of Par Value

Stella: And just let me point out that the reason I delved into this a bit in the paper is because I have to explain something that I've known for a long time. Again, looking at central bank balance sheets, is central bank balance sheets do mark to market accounting for the most part. So the Fed is quite an exception in this-

Beckworth: Oh, really?

Stella: ... respect.

Beckworth: That's interesting.

Stella: But certainly on the foreign reserve portfolio, which is an important part of the portfolio in many central banks, not in the US of course. And they're mark to marketing, they're managing it. And central banks over the years over my career have moved towards international financial reporting standards. The Fed is still using its own proprietary or its own manual hand accounting manual, which it can change when it wants. It's rather unusual, I would say. But other countries will do mark to market on the central bank side. So I encountered countries where foreign debt, let's say in dollars, was a big part of the government's debt and foreign reserves in dollars was a big part of the central bank balance sheet. And if you can imagine a situation where maybe they're completely hedged, so the country would have a hundred billion dollars in foreign debt and the central bank would have a hundred billion dollars in foreign reserves. And you quickly might say, well, why would they do that? Well, because the debt would be of lower maturity than the reserves, so it makes sense to have this hedge position if you can afford it. So what happens? There's an exchange rate, let's say appreciation or depreciation against the dollar.

Stella: And the country will treat its debt at the par value. In other words, they have to pay so many billion dollars over time and they won't change the domestic currency value of the foreign debt on the books. Of course, they'll have to pay more local currency eventually, but they won't change that. But the central bank will immediately make that change in the books. So you could have a situation where the central bank, let's say, makes a big gain on the foreign reserves because there's a depreciation and you might think, oh, the central bank is making lots of profits, we should transfer those to the government. But on the other side, you would say, well, wait a minute, the government's debt in local currency has gone up and we haven't realized that they're hedged, so we're just measuring the gain on one side of the sovereign’s balance sheet, we're not taking into account the other side. So you get into fights between Treasurys and central banks over these things that are really resulting from accounting conventions. So basically it's very, very conventional for governments to just look at the par value of their debt and not make any changes to it. But on the other side, it's very common for central banks to do it. So that's why in our context, the Fed doesn't do this, but other central banks would change the value of their claims on government. But the government wouldn't do the reverse, the government wouldn't get the market value.

Beckworth: Is my impression correct, though, that most people, most economists, most institutions, even when we talk about debt sustainability in the US, we just went to the debt ceiling here, people talk about debt to GDP. It seems to me that's often invoked is par value over nominal GDP. Is that impression right?

Stella: Right, and I would say, don't want to be too technical, but as long as expectations of interest rates are correct over time, the Treasury should auction at par at the market rate, and that more or less should be the market rate for the next 10 years. If it is well anticipated in equilibrium, let's say expected inflation is 2% and that doesn't change over a 10 year period. Then basically the value of that bond, if it's sold at par with a coupon, it will be very close to par until the redemption.

Beckworth: So it's good enough?

Stella: But what we've seen in many countries, certainly in the US since the Volcker disinflation, is that markets and everyone has consistently overestimated nominal interest rates in the future or inflation in the future. So if you look at projections of long-term interest rates over the last three decades, they've consistently been above the actual. So this is a, let's say, not an equilibrium situation, but it is a factual situation. So what that means is over time, the market value of those bonds will consistently trade above par because interest rates will be lower than people expected so they're making a gain. And eventually of course those bonds will come back to par, but you'll have a long period of time. And if you look at the series in the US, especially since the global financial crisis when interest rates were surprisingly low. So the average ratio of market value to par value in the US before COVID was about 8%. It was about 8% above par.

Stella: So basically what I'm saying is over time you wouldn't expect that, but of course markets are wrong sometimes and sometimes for a long time. So what we've really seen now is again, a flip in that. So interest rates rose unexpectedly around the world quite a bit. And so that brought the market value, to par value down to instead of being plus 8%, it's about minus 8%, which is a pretty huge change. So basically if you were in an equilibrium, or if you were… I'm not a modeler, but as you're modeling something, you wouldn't really model this difference because you'd say, well, rational expectations. So basically the idea is, this is a real surprise, so COVID and the reaction was a truly unanticipated shock and led to an unanticipated outcome, which has made this distinction very important to the point where, we discussed this earlier before the podcast, that the real market value of US government debt at the end of March 2020, in other words, right before COVID, was or is actually higher than the real market value of government debt at end of 2022, which seems impossible because all of this unexpected trillions of dollars of expenditure happened, trillions of dollars of nominal debt was issued that we didn't expect. But the rise in interest rates, the surprise rise in interest rates has actually lowered… accompanied with inflation, has actually lowered the real market value of US Treasury debt to… it was about $400 billion less in real terms than before-

Beckworth: That's amazing.

Stella: …Before COVID. So that's why I think it would be nonsensical, I think, to ignore this fact because in a sense, we’ve almost paid… as a nation with surprise inflation, have deflated away the real value of the debt that was created during COVID. So it's convenient in a sense, or maybe it's even optimal from a theoretical standpoint that-

Beckworth: Well, one way or the other, we were going to pay for that spending surge during the pandemic war. And what it turned out to be is inflation, and what you've you mentioned is really striking that the real debt burden, so debt adjusted for changes in prices, is actually less today than it was a few years back before the pandemic. And let me put it this way, I looked this up recently. The market value to GDP ratio… you're mentioning over the price level, but let me do it as a percent of nominal GDP, it peaked at 103% in December 2020, and then earlier this year it fell down to like 84, 83%. So it's fallen a long ways if you put market value over nominal GDP. So I just want to spend a little bit more time here to make this point clear. And so people can understand debt over the price level, prices going up or nominal GDP going up because of inflation.

Beckworth: Where they have a hard time, I think, is in the numerator where we plug in market value versus the par value. And so let me just share with you the flak I got back from this was they would say, okay, David, we get why you're doing debt to GDP, why nominal GDP would go up, but why are you putting that market value above? And I think what you wrote in your article is, well, the reason the market value is going down… well, it is going down because interest rates are going up. But the reason interest rates are going up is because the expected inflation part of that rate is going up and that expected inflation term represents an ongoing increase in the price level. So market participants are looking at not just the current real value today, but what they think it will be over the life of the security and pricing it in. So it is important to look both at the current real value, but also what the market thinks the real value is going to be over the duration of the life of the security. Is that fair?

Stella: So when I was writing the paper and doing this sort of, let's call it the bond arithmetic, and trying to figure out what it all meant, in the back of my mind, and there's a little section in the paper where I do a really basic… I say, okay, here's what would happen in a certain scenario to the par value of a bond, which basically is nothing no matter what happens with market interest rates. What happens if you use an amortized cost method, which is the method the Fed uses to price its bonds on the balance sheet. And then the market value, just to illustrate for people how this all works out in terms of the bond arithmetic. But the point is, all of these bonds, let's say we’re talking about a five year bond, all of these bonds reach par on the ultimate amortization day.

Stella: So I was puzzled to myself because I said, okay, so the market value of US Treasury debt has fallen below par, say 8% below par from being 8% above par. Now it's 8% below par, but in five years time, that bond is going to be worth par, right? So in some sense, doesn't this all go away in five years, these unrealized gains. Well, they will all go away because eventually this bond that's worth 92 today will be worth a hundred. So I was a little puzzled saying, okay, I've got to reconcile this in my own mind, and I said… it came to me, what you described, was that, well, what the market is saying is effectively, this is what we expect nominal rates to be over the next five years, and this incorporates what we expect inflation to be over the next five years.

Stella: So it's not just looking backwards and saying, okay, the price level is higher today than we expected it to be three years ago, but it's still going to be higher five years from now. And I don't think anyone thinks suddenly we're going to go from 5% annual inflation to zero. So in other words, the market is saying that the real value of these bonds is still going to fall, even though let's say the market price will eventually rise to par. And I tried to fit this in with what people call the fiscal theory of the price level, and I focused on the name of the theory. It's a very well developed theory. John Cochrane has a book out now. It's the theory of the price level, not the theory of the inflation rate. And I would normally be a practical person and think, well, this is just a theory, it doesn't matter.

Stella: But when I thought about it, I said, well, in the theory, the price level will jump immediately to establish this equilibrium condition where the value of the government's debt is equal to the present discounted value of the future surpluses. So in this scenario, we have the perfect experiment, unexpected $3 trillion or $4 trillion of spending. You would say, well, the price level should jump unless we think that taxes are going to be raised or expenditures cut by 3 or 4 trillion dollars in the future. But when you look at the real world, well of course price levels don't jump, the CPI doesn't jump because of staggered contracts and other reasons, there's inertia and so on. So you can't really have the price level jump to create the equilibrium like you would in the theory. And then I realized, well actually what the market is saying with these higher nominal rates is that they're expecting the price level to go up. It can't jump now, but the inflation rate will go up to make this equation hold at the time of a maturity of the bond, right?

Stella: So the government's going to issue a new bond in five years and people have the right expectations, this is going to be at par and go on at par. So that's the way I reconcile that, is basically the nominal interest rate the market is pricing in and the inflation that it expects that hasn't already occurred, whereas when you're dividing by the nominal GDP on today's nominal GDP, you're capturing the past surprise in inflation and jump in the price level, but you're not incorporating what's already in the market in terms of what nominal GDP will be five years from now. So that's why I think it's important. And all of this is so important, the expectations of fiscal policy and expectations of inflation, this is… the market is telling you this is what these cash flows are worth today.

Beckworth: Yeah. Now we've belabored this point, but I think it's important we move on. But just to summarize, to do good economics, you want to use the market value. Oftentimes par value will work, but when you get into moments with big surprises in inflation, you want to use the market value to do a good economic understanding of what's happening to debt burdens. Alright, let's go back now to mortgage backed securities. So we've talked about how Treasury losses on one arm of the government, the Fed, would be gains to another side, the Treasury side of the federal government. But let's talk about the mortgage backed securities. And you've already made the point that somebody, householders like myself, who refinanced at low rates, we're having this massive gain because I locked in a low interest rate and going forward there will be higher rates because of higher inflation. And so my real mortgage payments going forward are going to be much lower than I had initially anticipated. But the flip side of that is someone on the other end, my creditor, is getting a much lower real payment than they anticipated, and that's the taxpayer, ultimately the taxpayer. So walk us through that and you do an exercise in your paper where you try to account for that. And walk us through that and what are the implications and conclusions you take away from it?

The Mortgage Backed Securities Story and the Fed’s Debt Management Issues

Stella: Yeah, so when I was reviewing this, the Fed's balance sheet and the profit and loss situation, I became more and more convinced that the really big error was on the MBS purchases. And if you don't mind, I'm going to go back and-

Beckworth: Sure.

Stella: ... and explain why I think what the Fed did during the global financial crisis was absolutely the right thing to do with regard to… and by the way, the first assets that the Fed purchased under the Bernanke Fed were MBS. And I thought this makes complete sense. They did that before they started buying the Treasury securities.

Stella: So I thought that made complete sense. But the difference between the situation in 2009 and 2020 was dramatically different. So just let me go through that. So during the global financial crisis, there was an ongoing collapse in residential real estate prices and the securities, mortgage-backed securities, securities backed by those mortgages, were falling dramatically in value. They were a very important part of the holdings of the financial system, the banking system, used for collateral. They were rated AAA, they were as good as Treasuries until they became junk very quickly. And the impact of falling securities prices… and it's a huge market, trillions of dollars worth of securities. So the impact of that fall in those securities on an undercapitalized banking system that we had then, would've been absolutely catastrophic. And we also had deflationary forces in terms of, as I mentioned, real estate prices falling, rents were falling.

Stella: So if you broke down the CPI, people were worried about deflation, but if you broke it down into shelter, which is about… it's almost half of the CPI in the US, it's maybe 40, 45%, which is rents and imputed costs of owning a home and those elements. Those were actually in deflation, and the rest of the CPI was rising about 2%. So on average, yeah, it looked like we were close to deflation, but it was all centered on the residential real estate, commercial real estate, these markets. So to me, it made complete sense to focus on intervening in that market with the MBS purchases. That to me was absolutely correct for all those reasons. From the financial sector stability standpoint, from the policy standpoint, in terms of meeting your inflation target and in terms of let's say distributional cases and that these were the markets or the holders who were really adversely affected by the shock.

Stella: Now let's turn the picture to 2019. Okay, 2019 or right before COVID, what was going on there? Well, there was a sustained increase maybe over five or 10 years, no, five years I would say, of residential real home price appreciation, so real prices were going up. In other words, prices of homes were going up faster than inflation. You had already record low 30 year mortgage rates. The US financial system was much stronger, not in bad shape at all. And we had in 2020, the massive fiscal stimulus in an environment where I'm sure everyone can remember, people couldn't spend the money. Was this supposed to add to aggregate demand? People refinanced their homes. Well, David, what did you do in 2020? Did you go on a trip to Europe? Did you eat out in restaurants? No. So basically, all the reasons why I would have or I did support intervening in the MBS market in 2009 were the reverse in this situation. So, what happened? I think the Fed made a serious mistake.

Stella: At the very beginning there was a massive turmoil in all markets. And [for] those familiar with the mechanics of mortgages, you have a 90 day or 60 day pipeline of mortgage origination, and then the closing happens, and then the mortgage is put into a security and sold off to the market, so that might be 60 days or 90 days. That pipeline was frozen by COVID, completely frozen. So the Fed went in massively, massively unlocked the mortgages that were in the pipeline. Okay, fine, no problem with that. But then after that, the Fed had a target… So let's say that 60 to 90 day, absolutely warranted. But then what happened is the Fed adopted a target for increasing the amount of MBS on the balance sheet. So what does that mean? People are going to say, well, isn't it exactly what they had a target for increasing the amount of Treasuries on the balance sheet?

Stella: Yes, but what's the difference with MBS? The difference with MBS is people can refinance. So if you want to add, say, 50 billion a month to the stock, you're basically opening up the window on C Street and yelling out the window, anyone in America who wants to refinance their mortgage at the exceptionally low interest rates, we're going to buy those securities. So that's what happened. Mortgage rates fell to record lows. Yourself, other people… if I might say, everyone probably realizes this, homeowners are the wealthiest part of the US population. And the people who maybe didn't have a job or were working from home or the wealthier part of the population who own a home and could go to a bank and get a refinancing… I don't think lower middle class people who own their home could walk into a bank without a job and during COVID and refinance.

Stella: So basically the Fed opened the window and said, not only will we refinance all of the high coupon mortgages that we're holding now, but we're going to buy even more. So I think the choice of the target was very poor in that sense. So it's very different to say we're going to buy 50 billion a month from, we're going to add to the stock of 50 billion because in the mortgage area there's a possibility for massive refinancing. So you wind up buying trillions of dollars of mortgage backed securities at historically low rates. And so I think that was not only a financial mistake, a $400 billion financial mistake, it was a distributional mistake because the US taxpayer is on the losing end of that trade and the wealthier part of the population is on a gaining part of the trade. What else happened? We had, I think, 20 months of 17.5% house price inflation at an annual rate. And I know the real estate market in Florida, and it was crazy. It was in the middle of COVID. Investors were coming from Nevada to buy up homes, and why? Well, because rates were so low, how could they lose money? And they weren't losing money. Prices kept going up.

Stella: And then the last point I would make is that rents have gone up a lot more than the CPI. So the other part of the population who don't own a home, they're suffering from high rents. So not only did they miss out on the home appreciation, not only did they miss out on refinancing their mortgages at historic low rates, and they can hold onto them for 30 years, the renters are also being hit. And it's coming, I don't know the numbers now, but I think the end of December 2022, CPI for the rental of your primary residence was up about eight and a half percent. So I think it was a financial mistake of the Fed. It was a policy mistake because you create, I wouldn't say a bubble, but you definitely aided a real estate market that had no need to be aided and you contributed to inflation, which is a policy mistake. And then I think it was a serious distributional mistake.

Beckworth: So the inflation financing of all the spending went in part to people like me who refinanced our homes and helped us immensely, wasn't the best policy choice. Now Peter, let's go back to the Treasury question. So your big critique in your paper is, yes, the Fed should not have lost money, but only on the mortgage backed security side. Is that right? You're less concerned about the Treasury side?

Stella: Well, the way I look at… and this comes back to my opening rant about, QE is not like this one monolithic linguistic title that covers everything. So the way I look at it, I'm not the only one who looks at things this way, is the Fed's issuance of interest bearing money, which by the way is a liability of the US Treasury. You could look at the law. And by the way, I have a speech from 1997 [that] Alan Greenspan made in Belgium, where he says extremely clearly and repeatedly, the central bank can create liabilities that are liabilities of the state. So please don't misunderstand, I'm being very direct that this interest-bearing money is a liability of the state. So what the Fed's purchases of long duration Treasury assets and issuance of overnight floating rate Treasury instruments, let's call them Treasury instruments, is a manipulation or alteration of the maturity structure of the US government debt in the hands of the public. And by the way, the calculations that I gave earlier, which you also have in your article, exclude holdings of the Fed. So the reduction in the real market value of US Treasury debt that we were talking about would've been $800 billion larger if we'd include the Fed's holdings. But they're excluded from my numbers. So I'm looking at them separately.

Stella: So what was the, let's say, error, in this respect was you or the Fed shortened the duration of the US Treasury debt at a time when everyone such as yourself was lengthening the maturity of their debt to take advantage of historic low interest rates. Corporations were issuing long-term debt at historically low rates. Those real estate investors from Nevada were presumably issuing debt at historically low rates to buy homes. And here the US Treasury and the Fed were lowering the duration of their debt. And obviously that, ex-post, wasn’t such a good idea because interest rates went up… and the counterfactual is the Treasury, let's say, had issued ten year debt, which some countries did, by the way. Treasury and Canada explicitly said, we're going to take advantage of these historically low interest rates, and lengthen the maturity of our debt. So in this case, the Fed followed the same playbook of the global financial crisis and continued to issue these short term instruments and took on this interest rate risk, which is now being realized. So that's the $800 billion loss from the… let's say the consolidation. So instead of the US Treasury having issued during 2020, 2021 or 2022, long-term debt, ten year debt, it issued overnight floating rate debt and that-

Beckworth: So that wasn't good public debt management.

Stella: That wasn't, yes.

Beckworth: And I know we've talked about this before, that that really shouldn't be the Fed's business. That's really the Treasury's job to manage the portfolio of debt, the average maturity. But the Fed, by expanding its balance sheet so rapidly by default, also becomes an important player in determining the average maturity. So your critique is more that the Fed is wading into public debt management as opposed to it's incurring these losses. The losses are unfortunate, but it's more that they're meddling in a place they shouldn't be?

Stella: Right. And basically the question is how you manage the risk of this in the UK and in Canada, the government indemnified the central bank against losses. So actually right now the UK Treasury is transferring cash to the Bank of England to cover its losses on its holdings of government debt. I'm not saying that's a perfect way, but I'm just saying at least there was some forethought of how are we going to handle this. As I mentioned with regard to the QT as being done differently in different places, New Zealand has a different way of handling this, which is interesting. But it is a question, and I think it's a fairly deep question. Some people have been pondering this for some time. Larry Summers, I think, is one of them who… we were thinking, if this idea of the maturity structure of the sovereign yield curve is going to be a policy instrument, have we discovered a new policy instrument?

Stella: It's not just the overnight rate, now it's the risk adjusted, somehow, yield curve. We want to take risk out of the market, rather. Okay, suppose we accept that that's a valid policy tool. Well, we have to coordinate that somehow because the Treasury's job, as you of anyone would know, is to minimize the risk adjusted cost of financing the government's debt. And that's the objective in the US and the UK and basically every country. So these are often independent entities, the debt managers, they're independent from politics and say, okay, this is our job. And this conflicts with the idea of, oh, the central bank is lowering the 10 year bond rate. From their point of view, they should be issuing in the 10 year space, undoing what the central bank is doing. So it creates a conflict. So it has to be decided like, okay, if is this isn't a new tool, who's deciding what to do and how is it going to be coordinated? Because right now we have two entities that have very different mandates and objectives. They were designed to be that way, but we had a consensus probably for 20 or 30 years. And the way I look at it is the Treasury auctions, at the market rate, all of the government debt from cash management bill three day duration to a 30 year bond, or in some countries 50 year, 100 year bond.

Stella: We need to raise a certain quantity, market sets the rate, and then the central bank says, you can have as much reserves or bank notes as you want, but at my target interest rate, so there's always a tiny bit of the yield curve where the central bank said, okay, we're going to. They're both monopolists, so the central bank is saying, we're going to ration by price, and the Treasury is going to ration by quantity. They say, we establish the quantity, the market tells us the rate, and the central bank sets the rate, and then you decide how much you want. So that was a consensus, I would say for 20 or 30 years. And now we're seeing this conflict, right? Because the central bank is stepping into the Treasury space and it's having fiscal consequences or quasi-fiscal consequences. So I think that's a deep question. Do we go back to the old way and you say, no, we need to go... And so that's a big question, but it seems clear to me it has to be discussed, agreed, and coordinated. Doing it the way it's being done doesn't make sense because you have the central bank basically saying, we don't care about these losses. This is nothing to do. Our objective is to combat inflation and this is what we do. And so it's really a question about governance of macro policy. And if I can just step back to the MBS issue.

Beckworth: Yes.

Stella: I think we've discussed this before, but different countries did this in different ways. Canada didn't do, I'll use the term QE, during the [global financial crisis]. It did during COVID. So that's in this IMF case study that I wrote. So originally in the global financial crisis, the Canadian… there was a Canadian mortgage company, public owned company, that did the intervention in the mortgage backed securities so it wasn't on the balance sheet of the central bank. So there are different ways to doing it, but in the US, people forgot that during… it actually started in the Bush administration, the Treasury started buying mortgage backed securities and debt of the GSEs. It was part of law. It was subject to, had to be passed by Congress. There were limits on how much the Treasury could buy. Of course, the debt the Treasury issued to get the cash to buy those mortgages fell under the debt ceiling, and then in about 2011, 2012, under the Obama administration running up against the debt ceiling. So what happened? The Treasury actually auctioned off all of the MBS that it had bought. So they disappeared. People forget that this happened.

Beckworth: It's possible.

Stella: It did happen.

Beckworth: It's possible.

Stella: And it happened because there was the law and the debt ceiling. I'm not a big fan of the debt ceiling, but the debt ceiling in this case compelled the Treasury to sell the MBS, whereas the Fed started doing literally the same thing, buying MBS. There's no limit on how much it can buy. It's not subject to any legal constraints or those sorts of things. So you really get into this question of, does it make sense to have two... This is exactly what quasi-fiscal is. It's quasi-fiscal because it's something that the government can do and has done, but it's being done by the central bank under a different governance structure. And it matters. It matters.

Beckworth: So Peter, there is this tension between what the Fed is doing, what the Treasury wants to do. There are cross purposes sometimes in terms of the direction for the maturity, duration, and structure of public debt. And one of the things you have proposed is that if the Fed does find itself in a situation like it's in today, the government could transfer the liabilities on the Fed's balance sheet over to the Treasury. And you have a paper a few years back called, *Exiting Well,* which was after the great financial crisis. Maybe walk us through that as a potential solution or partial solution to some of the challenges we find ourselves in today.

Potential Solutions for the Current Balance Sheet Issues

Stella: So there's different ways to do this. Actually, I alluded to New Zealand a couple of times already, but in their version of quantitative tightening, the Treasury is actually in the process of buying back the bonds on the balance sheet of the Reserve Bank of New Zealand. And the question is, okay, at what price, naturally. So in other words, to speed up the removal of these assets that, as we've discussed, are falling in value on the central bank's balance sheet, and to speed up the process, the New Zealand Treasury is buying them back from the Reserve Bank of New Zealand at basically the average market rate in the month in which they're doing it. So there's an agreement that they will buy them back at a certain rate and they're going to be bought back at the market rate. So basically the New Zealand Treasury is issuing debt in the market at a certain rates and then using the cash to take those off the balance sheet at the Reserve Bank of New Zealand. And it's very transparent, public, at the market prices. Now in that paper, *Exiting Well,* and just a little parenthesis, some people might think, oh, he's Monday morning quarterbacking, he didn't see this coming, whatever.

Stella: No, I'm sorry. I've been talking about this since 2009, 2014. That paper, *Exiting Well,* hasn't been touched since 2015. And it's funny because I said to one of my deputies when I was still at the IMF in 2009 when the Fed did its first intervention, I said to him, he was a former central bank governor by the way. I said to him, Luis, if the Fed makes money on this, no one is going to care. No one cares. And they did make money, not risk adjusted return, but they didn't make any losses and nobody cared, right? So I've been sitting here 10, 12 years later and now it's happened, right? So please don't say I'm a Monday morning quarterback. I've been saying this for a long time. And those losses wouldn't have been so large if the Fed had shrunk its balance sheet-

Beckworth: Sooner.

Stella: ... More aggressively in 2015, 16, 17, 18. So that's a parenthetic observation before I say, well, it's pretty late now to do much about it because the Fed has already made the losses, but here's how you would do it. One way to do it, certainly, you would have the ability, and you could do this in a paragraph long law, which maybe is impossible in the US, but it is in the economics world. You'd basically say, the Treasury is going to start issuing bonds. We're going to give them a special name, the monetary stabilization bond. They're going to be exactly like all the other bonds that the Treasury issues. So why do we give them a special name? We give them a special name because the issuance of this debt, first of all, the proceeds will be frozen at the Fed.

Stella: They can't be used to finance any spending. And second of all, it will not count against the debt ceiling, right? They're not financing any spending so why should they count against the debt ceiling? So this is an idea I invented. This is… Israel has this in place. Other countries have a similar thing, similar option. So basically you would have the Treasury issue debt according to however it wished to… however the debt managers thought was the optimal way to is issue debt. And that would, first of all, reduce the amount of interest bearing reserves and overnight repo facilities and so on, basically one for one. Well, the Fed isn't sterilizing, but it's effectively… the Treasury would be what we call in the old days sterilizing the monetary injection of the Fed. And what I argued in *Exiting Well,* and there were certainly periods where the Treasury, because people would rather have a one year, oh, sorry, one month Treasury bill or three month Treasury bill than an overnight account at the Fed, because you can use a security as collateral and you could trade it with anyone in the world.

Stella: Right now, only people who can hold an account at the Fed can get interest on reserves, but anyone in the world can hold a Treasury bill and get interest and so on. So it's actually more efficient for the Treasury to finance using securities than with an overnight account at the Fed. That's why you didn't see anyone at the Treasury come up with this idea. “Oh, this would be a great idea.” No, this is not a good idea to have this floating rate overnight debt. So that's one way to shrink the interest bearing liabilities of the Fed, and I think it would save the taxpayer money. But secondly, you could also have the same scheme where the Treasury issues debt however it wants and simply goes to the Fed and says, okay, we're going to buy… we're going to redeem the debt early. There's nothing wrong with that. The US Treasury for some time hasn't really done these operations in the market, but other treasuries do them all the time. They decide, okay, we're going to buy back some debt and we're going to issue a new debt to finance the buybacks of the old debt. And I very recently saw-

Beckworth: Yeah, Treasury announced they'd do that.

Stella: … The Treasury announced. Yeah. So I thought, okay-

Beckworth: Yeah, well, there you go, Peter.

Stella: This is great.

Beckworth: Your prayers have been answered.

Stella: I wish it had happened like five years ago, but okay. But yeah, it's not rocket science. It's simply-

Beckworth: So the new Treasury buyback program could be used to implement your vision here?

Stella: Right. Of course, it's tricky to agree on the price. Does the Treasury pay par or does it... That's something that can be useful sometimes because you can actually make the debt stock go down by buying back below par-

Beckworth: And just be clear, we're just transferring liabilities from one arm of the government to the other, from the Fed to the Treasury. But what we'd be doing is putting the liabilities under the institution that was designated by Congress to be the debt manager.

Stella: Absolutely. So in some countries, I've been talking to countries for 10 or 15 years about doing this with the central bank debt, as you mentioned earlier, with respect to Chile. But also in those countries, it's also obviously the Treasury that's managing the foreign debt too. So it's simply putting it where it is designed to be.

Beckworth: Well, we are running near the end of our time. I do want to make sure and mention that the IMF working papers that I noted earlier, we don't have time to get into them, but I would recommend listeners go check it out. We'll have links in the show notes. The title of the papers are, *Quasi-Fiscal Implications of Central Bank Crisis Interventions.* We touched on a lot of similar things that are in this paper today. And then also, *Quasi-Fiscal Implications of Central Bank Interventions: Case Studies,* where they look at a number of countries. Well, Peter, thank you once again for coming on the show.

Stella: Yeah, thank you, David. It's great to be back.

About Macro Musings

Hosted by Senior Research Fellow David Beckworth, the Macro Musings podcast pulls back the curtain on the important macroeconomic issues of the past, present, and future.