Kenneth D. Garbade
From time to time, and most recently in the April 2014 meeting of the Treasury Borrowing Advisory Committee, U.S. Treasury officials have questioned whether the Treasury should have a safety net that would allow it to continue to meet its obligations even in the event of an unforeseen depletion of its cash balances. (Cash balances can be depleted by an unanticipated shortfall in revenues or a spike in disbursements, an inability to access credit markets on a timely basis, or an auction failure.) The original version of the Federal Reserve Act provided a robust safety net because the act implicitly allowed Reserve Banks to buy securities directly from the Treasury. This post reviews the history of the Fed’s direct purchase authority. (A more extensive version of the post appears in this New York Fed staff report.)
Federal Reserve Banks actively used their “direct purchase authority” during World War I and for a decade and a half afterward. Direct purchases typically occurred when Treasury cash balances ran low shortly before a tax payment date or the settlement of a public securities sale. The Fed would then purchase a one-day certificate of indebtedness, rolling over the investment one day at a time until Treasury’s coffers had been replenished and the debt could be retired.
In 1935 Congress acted to prohibit direct purchases of Treasury securities by Federal Reserve Banks. Treasury officials were not happy with the prohibition. In a letter to the chairman of the Senate Banking Committee, Under Secretary of the Treasury T. J. Coolidge questioned “whether in times of emergency it might not be important to permit a direct loan. This might have been the case in the bank holiday in 1933 had there been a sizeable note issue coming due when the banks were closed. It might be the case in time of war.”
The historical record does not provide a clear explanation for the prohibition. In the 1940s, Marriner Eccles, the Chairman of the Board of Governors of the Federal Reserve System, suggested that the prohibition might have been intended to prevent excessive government expenditures or chronic budget deficits. W. Randolph Burgess, a past Manager of the System Open Market Account, suggested that it might have been intended to limit expansion of Reserve Bank balance sheets. (The Glass-Steagall Act of 1932 provided, for the first time, that Federal Reserve notes could be backed by Treasury securities as well as by gold and commercial paper.) However, neither explanation is particularly plausible because Congress did not concurrently limit the authority of the Federal Reserve to purchase Treasury securities in open market transactions.
Following the entry of the United States into World War II, Congress—anticipating a long struggle that would require unprecedented expenditures and concomitant financings and that would present novel cash management problems—provided a $5 billion wartime exemption to the prohibition on direct purchases. Acting on the basis of that exemption, the Fed purchased certificates directly from the Treasury during the war much as it had during the 1920s and early 1930s: to replenish Treasury cash balances on a day-to-day basis before taxes were received or securities were issued.
Following the conclusion of the war, Congress renewed the $5 billion exemption for three years and continued to renew it from time to time thereafter, until 1981. The lapse of the exemption in 1981 was attributable to two innovations in Treasury cash management. The first was the introduction of short-term cash managements bills (CMBs) in August 1975. The initial offering was $1 billion of eighteen-day CMBs and was followed with four more issues before the end of the year. The new program—which showed that Treasury could access the public markets for short-term funding on as little as one or two days’ notice—soon displaced most direct sales of Treasury debt to Federal Reserve Banks. In 1979, Federal Reserve Governor J. Charles Partee testified that “the direct [purchase] authority . . . has come to be used only infrequently,” because “the Treasury now often relies on short-dated cash management bills to cover low points in its cash balance prior to key income tax payment dates.”
The second innovation was a 1978 overhaul of the Treasury Tax and Loan (TT&L) system that allowed Treasury to earn interest on TT&L balances at commercial banks. The overhaul materially reduced the cost of maintaining deposits at those banks, allowing Treasury to maintain a larger cash buffer against fluctuations in its receipts and expenditures.
Short-term CMBs and larger TT&L balances were not perfect substitutes for direct issuance to the Fed. Both required notice of at least a day or two, while a direct sale to the Fed could be arranged within a matter of hours. Additionally, of course, CMB issuance required that the public markets be open and functioning. Assistant Secretary of the Treasury Paul Taylor noted in 1979 that “If a market were disrupted, it might be very difficult to consummate [an offering]. If the market were already disrupted because there had been an earthquake because the San Andreas Fault had broken up and down California, or if war had been declared, or if some major event of that kind had occurred, you might find the market would not be functioning very well.” Taylor’s warning gained credibility following the terrorist attacks on September 11, 2001, when Treasury was forced to cancel a four-week bill auction, and as a result of disorderly market conditions on August 21, 2007, when an auction offering of four-week bills very nearly failed.
In June 1979, Congress renewed (for two years) the $5 billion exemption to the prohibition on direct purchases, but limited the exemption to “unusual and exigent circumstances” and required approval by a super-majority (five members) of the Board of Governors of the Federal Reserve System. The conditions suggest that Congress believed that the combination of short-term CMBs and larger TT&L balances provided an adequate safety net for virtually all Treasury operations and that authority for direct purchases could reasonably be limited to highly exceptional circumstances.
Treasury never issued securities directly to the Federal Reserve under the terms of the 1979 renewal, and the exemption was not renewed in 1981. Since that time, the Treasury has lacked a robust safety net that would allow it to meet its obligations in the event of an unforeseen depletion of its cash balances.
The views expressed in this post are those of the author and do not necessarily reflect the position of the Federal Reserve Bank of New York, or the Federal Reserve System. Any errors or omissions are the responsibility of the author.
Kenneth D. Garbade is a senior vice president in the Federal Reserve Bank of New York’s Research and Statistics Group.