In reality, however, the Fed is an agent of Congress — or more precisely, a fiscal agent — and, in a crisis, is subservient to the Treasury.
During World War II, for example, the Fed supported the prices of US securities and pegged interest rates at artificially low levels to finance government deficits. The pegged rate system didn’t end until 1953, even though the Treasury‐Fed Accord was announced in 1951.
Today, in response to COVID-19, the Fed has once again become a major player in funding massive increases in government deficits. It has promised to more than double the size of its balance sheet by engaging in large‐scale asset purchases of Treasuries and mortgage‐backed securities.
The Fed also has created off‐balance sheet entities — special purpose vehicles — backstopped by the US Treasury with funds appropriated by Congress under the CARES Act (Coronavirus Aid Relief and Economic Security Act).
Congress has provided the Treasury with $US454 billion ($700 billion) to cover potential losses from the Fed’s emergency lending programs. That backstop will allow the Fed to lend as much as $US4.54 trillion.
Although the Fed — unlike the Bank of Japan and, more recently, the Reserve Bank of Australia — has not officially pegged interest rates on government debt, there has been talk of establishing “yield curve control”. The idea is to have the Fed commit to buy longer‐terms bonds to support their prices, and thus peg their yields at whatever rate is decided upon, most likely under consultation with the Treasury.
Although the Fed may see this as a way to stimulate the economy, it could also be a way to fund fiscal deficits at an artificially low rate.
According to Sage Belz and David Wessel, of the Brookings Institution, “a major risk associated with yield‐curve policies is that they put the central bank’s credibility on the line” — that is, if the Fed promises to peg rates, it runs the risk of straying from its inflation target.
In the case of Australia, the central bank has set a 0.25 per cent target for the yield on three‐year government bonds, which meshes with the cut in its cash rate target.
The Reserve Bank distinguishes its yield control approach from quantitative easing. Rather than announce a target for the quantity of bonds it plans to buy, it says it will buy an unlimited quantity of government bonds to keep the bond yield at its targeted low rate.