Fed can handle reserves to keep US rates on target

Copyright 2005 The Financial Times Limited (London, England)
Wednesday, September 21, 2005; Financial Times; USA Edition; Letters to the Editor

Sir, In his article, “Only leadership can defuse America’s fiscal time-bomb” (September 15), Jagadeesh Gokhale claims that US fiscal deficits will force the Fed to face a “surfeit of Treasuries,” leading it to put too many dollars in circulation as it buys excess bonds; and that the fiscal deficits will lead to slow productivity growth and high unemployment by “eroding the capital stock.”

With respect to the first claim, Mr. Gokhale misunderstands reserve accounting. Budget deficits lead ceteris paribus to net credits to banking system reserves that are drained through bond sales—either open market sales by the central bank or new issues by the Treasury.

The central bank would only buy Treasuries if banks were short of reserves—an unlikely event in the current situation with annual budget deficits of at least $330bn.

In any case, central bank interventions are automatic, triggered by excess or deficient reserve positions of banks that cause the overnight interest rate to move away from target.

There is no plausible circumstance in which the Fed would not be able to provide or withdraw reserves to keep rates on target.

Mr. Gokhale’s second claim appears to be based on the “crowding-out” argument—that a budget deficit absorbs private sector saving, leaving less to finance private investment. He is ignoring the fact that the current account deficit, now 6.3 per cent of gross domestic product, makes the large budget deficit necessary if aggregate demand is to be sustained. If the government were now to cut its deficit without increasing net export demand, it would only succeed in reducing output, thereby reducing saving and investment as well.

Whether or not the current fiscal stance is the correct one, it is not creating any operational difficulties for the central bank, nor is it reducing the private capital stock by absorbing saving.

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