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Crescenzi: Fed's Treasuries Running Out

Tony Crescenzi

Editor's note: This column originally appeared on RealMoney.com.

The Fed had close to $800 billion of Treasuries at the start of the year. Last week the Fed had $479 billion in Treasuries, of which $200 billion was pledged to the term securities lending facility, the facility whereby the Fed lends its Treasuries to dealers in exchange for agencies, mortgage-backed securities and other non-Treasury collateral.

If the Fed lends $85 billion to AIG(AIG Quote), the Fed's Treasury holdings will be down to $195 billion. The tally is so low that it is becoming imperative for the Fed to take actions to enlarge its balance sheet.

As I've been noting for some time and emphasized since Sunday, the way for the Fed to enlarge its balance sheet is to ask Congress for the authority to pay interest on bank reserves, speeding up authority already granted, but not until 2011.

By paying interest on reserves, the Fed can purchase unlimited amounts of Treasuries, agencies, and mortgage-backed securities and hence inject vast amounts of money into the banking system, without affecting the fed funds rate.

There would be no impact because banks with excess funds can sell those funds to the Fed, hence preventing a plunge in the funds rate, which would be otherwise occur because of the massive amounts of new money in the financial system. A drop in the funds rate would be undesirable from an economic standpoint, because it might stimulate the economy excessively.

There should therefore be no fear about the Fed's ability to continue to provide capital for the financial system. Some observers will worry that any enlargement of the Fed's balance sheet will boost inflation risks.

Offsetting this at the present is the fact that bank credit has been contracting in recent months, the first such occurrence in about 50 years. This means that banks are shrinking their balance sheets, reducing the credit they extend via loans, leases and securities purchases.

Only when bank credit begins expanding at a pace that exceeds what is needed to obtain the maximum sustainable growth rate for the economy would any enlargement of the Fed's balance sheet become an inflation threat. By that time, the Fed would almost certainly be boosting the fed funds rate and reducing the growth rate of bank reserves.