For The Fed, The Downside Of Being Debt Free

Dwindling Treasury debt is not only a problem for Social Security. It's causing headaches for Federal Reserve Chairman Alan Greenspan and his monetary mandarins, too. To satisfy the public's demand for cash, the Fed regularly pumps money into the financial system by buying Treasuries from an elite band of securities dealers. Over the years, the Fed's portfolio of U.S. government debt has gradually grown to about a half-trillion dollars as demand for U.S. currency has increased along with the economic boom.

But that modus operandi won't work much longer. Thanks to ballooning federal budget surpluses, the Treasury is rapidly paying off the government's debt. If the economy keeps on growing as strongly as it has, the Treasury market could disappear altogether sometime in the next decade.

The Fed will have to deal with a dearth of Treasuries much sooner than that, though--perhaps as early as 2003, according to estimates by Goldman, Sachs & Co. chief economist William C. Dudley. That's because the central bank has decided to limit its ownership of individual Treasury issues to no more than 35% of the available supply. While that guarantees that the Fed won't unduly influence the price of any individual security, it also means that the central bank will run out of Treasuries to buy sooner.

So what are the Fed's options? It could decide to purchase bonds issued by borrowers other than the Treasury. Among the possible candidates: foreign governments, mortgage giant Fannie Mae, and other highly rated American corporations. But such a move would leave the Fed open to accusations of favoring some borrowers over others and allocating credit.

A more promising route would seem to be reform of the Fed's so-called discount window, through which it lends money directly to banks in economic emergencies. Right now, banks rarely borrow from the discount window because they're afraid of being seen as having financial difficulties. If the discount window were revamped to include credit lines that could be tapped routinely, then the stigma might disappear. "It may be appropriate to consider steps to reform the discount mechanism," says Kansas City Fed Senior Vice-President Craig S. Hakkio.

But even that solution is not without problems. To guard against possible losses, the Fed requires that banks borrowing from the discount window put up securities as collateral. Because the discount window is so infrequently used, investors don't pay much attention to what collateral the Fed accepts and what value it puts on those securities. That presumably would change if the discount window became more active. And experts say the Fed's choices would inevitably affect the way such securities were priced in the market.

Mindful of the complications, the Fed has set up an internal committee to study the problem. The panel is due to make recommendations early next year. But no matter what it decides, it's clear that life won't be as easy for Fed money managers as it was when the Treasury was deeply in debt.

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