With the supply of Treasury bonds declining, the Federal Reserve is considering what other kinds of securities it might use to conduct monetary policy, but bond market experts say agency debt is its only realistic option under current law.

The Fed regulates the economy by controlling the money supply. One way it injects liquidity or drains it from the economy is by buying or selling securities, most of which are Treasuries.

But the supply of Treasury securities is dwindling because of buybacks prompted by budget surpluses. In a January study, the Congressional Budget Office projected that Treasury debt would fall to $941 billion by the end of 2010 from a projected $3.5 trillion at yearend 2000.

As Treasuries have become scarcer, the Fed has begun using agency debt and mortgage-backed securities guaranteed by the two major government-sponsored enterprises in its open-market operations. Some Wall Street sources speculate that agency debt will eventually eclipse Treasury supply. In the fourth quarter of 1999, the combined outstanding debt of the government-sponsored enterprises was $3.9 trillion; outstanding Treasury obligations totaled $3.65 trillion.

"It's a point of distinction," said Peter Horvath, director of debt marketing at Freddie Mac. Indeed, the use of agency bonds in open-market operations would seem to support the case for Fannie Mae and Freddie Mac debt as a new benchmark for the board markets as Treasury volume shrinks.

However, minutes from the Federal Open Market Committee's March meeting released last week said the Fed supports a broad study of "alternative asset classes," which could be used to regulate monetary policy in the face of "paydowns of marketable federal debt."

Though the committee voted to continue using agency mortgage-backed securities to regulate monetary policy, the minutes specified that "the requested temporary expansion of authority" into mortgage-backed securities "should not be read as indicating in any way how the committee might ultimately choose to allocate the portfolio." Newspaper reports implied that this meant the Fed was reluctant to increase Fannie and Freddie's clout in the bond market.

One analyst, who did not want to be identified, said the Fed was only interested in dealing with securities that are risk-free and liquid enough so it can buy and sell them without affecting yields or spreads in the marketplace.

He said that in the long term, the only alternative to agency bonds is to use bonds issued by the World Bank or the European Investment Bank. But the problem with that, he said, is that there is not enough supply of these bonds for the Fed to be able to manage the economy.

"If the Fed needs to add or drain liquidity in the banking system, a few billion dollars is not going to help," he said. "Our economy is so huge, the volume of transactions is so mammoth, that the Fed needs to deal in size to be influential. If it's not going to make a difference, why bother?"

Another analyst said since Treasuries are held by dealers in smaller volumes today than in the past, not enough of them are held to make them a viable instrument of monetary policy. "The Street doesn't have them to lend anymore. As a result, the Fed can't add or drain reserves using only Treasuries," he said.

He added that the Federal Reserve could add AA- or AAA-rated corporate bonds to the mix but that such a change would require an act of Congress. Fed Chairman Alan Greenspan said in a March 10 letter to Rep. Spencer Bachus, R-Ala., that the Fed might ask to use corporate bonds "if at some future time it should become apparent" that this was necessary.

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