Will the Federal Reserve System Continue to Pile on Government Debt?

As of December 2011, the Federal Reserve System is the second largest holder of U.S. Government debt (USD1.6 trillion) with the largest holder being the Federal old-age and Survivors Insurance Trust Fund (USD2.5 trillion). Further, the Federal Reserve and Intragovernmental holdings amounted to USD6.4 trillion for the period ended 31st December 2011.

This article looks into the largest holders of U.S. Government debt and discusses why the Federal Reserve System would continue to pile on government debt. 

Before discussing these factors in details, I would like to present two charts, which would help me take forward the discussion.

The largest holders of U.S. Government debt as of December 2011
Largest holders of U.S. Government Debt as of December 2011

Increase/Decrease in U.S. Government Debt in last 2 years (Dec 09-Dec 11)
Change in holdings of Treasury Securities with largest holders of Debt

As evident from the second chart, the Federal Reserve has been the largest buyer of U.S. Government Debt in the last two years. It is also important to mention here that nearly 42% of the U.S. Government debt is now with the Federal Reserve or under Intragovernmental holdings. 

Will the Federal Reserve continue to pile on government debt to be the single largest holder of U.S. Government debt?

The answer is a relatively confident YES (in my opinion).

The Reasons

The economic activity has been largely supported by leveraging of the government sector. Therefore, any sluggish growth will again result in more quantitative easing (official or backdoor). This, in turn, would increase debt.

China, one of the largest buyers of U.S. Government debt has been conservative in their purchase of debt. In June 2010, China had USD1.11 trillion of U.S. government debt.As of December 2011 (19 months later), China's holdings of debt is USD1.15 trillion. During the same period, the total Government debt outstanding has increased by USD2.2 trillion. Clearly, China has not been a participant in the recent lending to U.S. government. 

Japan, the fourth largest holder of U.S. government debt reported its first deficits since 1980. Japan already has a huge public debt and its reliance on exports to finance the debt comes under scrutiny due to the deficits. Clearly, deficits and significant public debt are not the best combinations, which would encourage Japan to be aggressive in their purchase of U.S. government debt.

The CBO expects budget deficits to be in the tune of USD10 trillion over the next ten years. With the current perception towards U.S. debt and the outlook in their respective countries, foreign buyers would not really be interested in piling on Treasury securities. Therefore, the deficit financing (a large part) might happen through Intragovernmental sources and the Federal Reserve System.

Globally, inflation is high due to higher crude prices coupled with higher agricultural commodity prices. Adjusted for inflation, the returns on longer-term Treasury bonds is negative for most Asian countries. This does not give any incentive big incentive to buy Government debt. 

Geopolitical tensions are on a high globally. Any conflict in the Middle-East can result in flight to relatively safer assets. However, war would also mean that crude and commodity prices spiral higher. In such a scenario, investors might prefer being in hard assets than owning a promise to pay in the future (in a much depreciated currency). 

Conclusion

Eventually, the Federal Reserve System will be the largest holder of Treasury Securities along with other government organizations in the United States. The foreign holdings of U.S. debt will trend down in all probability (as a percent of total debt outstanding).

The implications might be too early to discuss as there are many other factors involved in determining the fate of a currency.

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