WASHINGTON — An idea that once seemed far-fetched — letting the Federal Reserve Board issue its own debt — is gaining traction as the central bank prepares to flood the market with billions of dollars to resuscitate bank lending.
The concept is one of two leading ideas that would give the Fed increased funding while allowing it to wield more control over liquidity in the markets. The alternative calls on the Treasury Department to sell more debt and send the proceeds to the Fed.
The Fed and the Treasury have not publicly chosen between the two options, and other alternatives might be developed, but just the possibility that the central bank will offer its own debt has touched off a series of policy questions, including how it would affect the Fed's independence, or at least the market's perception of it.
Some critics also argue that it could disrupt the market for Treasury securities and ultimately swell the Fed's footprint.
"The Fed is expanding far too much and in far too many ways," said Allan Meltzer, a professor at Carnegie Mellon University and a noted Fed historian.
Selling debt notes "opens the spigot full force" Meltzer said. "There's nothing to stop them from expanding if they can start selling their own bonds."
But others say the idea makes sense, especially given the Fed's growing burden as it continues to direct liquidity into the markets. The Fed said Tuesday that it would begin $200 billion of subscriptions March 17 for loans under the Term Asset-Backed Securities Loan Facility. The central bank might lend $1 trillion through that program.
"The first thing is they need more money to lend," said Douglas Landy, a partner at Allen & Overy LLP and a former lawyer at the Federal Reserve Bank of New York. "Their balance sheet is at a max. There are limits to what they can do, and they are reaching them."
Under the alternative option, where the Fed would receive more money from the Treasury, Congress would have to approve an increase in the federal government's debt ceiling. If the Fed sold its own debt, it likely would not be under any such restriction, giving it much more flexibility to fund its liquidity programs.
Oliver Ireland, a partner at Morrison & Foerster LLP, said giving the Fed authority to sell debt would also curb inflationary pressure that might result from dumping so much money into the market. "I'm putting money into the system, but if I want to drain money out of the system, and I don't want to sell the assets I had, this might be a vehicle … to drain money from the system."
But many questions remain open. One is how debt investors would respond to notes from the Fed. "They certainly should be regarded as equivalent" to Treasury securities, said Gil Schwartz, a former Fed lawyer who now works in private practice. "If you have an obligation of the Fed, and you want to be paid, the Fed can either default — which is never going to happen — or they're going to create reserves to pay you. That's better than what the government can do, because the government can't create reserves. The government can only borrow money in the marketplace to pay you, or they have to raise taxes."
But Chris Low, the chief economist at First Horizon National Corp.'s FTN Financial Capital Markets, said investors might be leery of any form of government debt, especially as the Treasury nears the debt ceiling.
"If the Treasury can't borrow more to lend to the Fed, there's not going to be any appetite for Fed debt, either," he said. "I don't think, in the eyes of investors, there's any difference between the two. It's just a slightly different flavor of government debt."
And Congress might not be thrilled at the prospect of giving such power to the Fed when concerns about government deficits are mounting.
"Certainly, some fiscal conservatives may say, 'Wait a minute — this is going to be issued without any control or oversight?' " Schwartz said. "At least today the Treasury has to come to Congress to borrow beyond the debt ceiling. There will be some members of Congress who view this as a threat to their role as overseer of the fiscal operations of the government and will regard it as potentially competitive."
Still, Congress will have to make some type of decision if the Fed continues providing liquidity at its current rate. The Fed and the Treasury are drafting legislative language, but that process has not been finalized.
Observers differed on whether either option could erode the Fed's independence. Low said the one positive that could result from letting the Fed sell its own debt would be increased detachment from other arms of the government. "If anything, it enhances the Fed's independence, because it means that they won't be constrained by the Treasury's ability to give them the money they need to fund these various programs," he said.
But Meltzer said the Talf has already shredded the central bank's independence.
"The Fed is no longer independent when the Treasury secretary gets up and announces the Fed is going to make a trillion dollars of purchases," he said. "That's the end of independence."
