The Dangers of the Federal Reserve Being the Only Buyer of US Treasuries: Inflationary Risks and Economic Unrest

The US national debt, reaching nearly 30 trillion dollars, poses a significant challenge for the global economy. Open market operations, a crucial aspect of the Federal Reserve's monetary policy, involve buying US Treasuries to inject liquidity into the economy and lower yields when the market needs it.
However, an intriguing question arises: what would happen if the Federal Reserve were to become the only buyer of US Treasuries? This scenario unfurls magnified risks, particularly inflationary pressures and systemic economic risks.

Demons of Inflation: Overheating the Economy

First and foremost, if the Federal Reserve were the sole buyer, the circuit of cash would flow without a mechanism for tightening monetary policy. This lack of control means interest rates would remain unnaturally low, leading to the overheating of the economy.

The Overheating Economy: With low interest rates and an abundance of cash circulating through an already overheated economy, inflation would be an inevitable consequence. This scenario represents a ticking time bomb, as there would be no cushion to mitigate economic fluctuations through traditional tightening measures. The absence of this mechanism leaves the U.S. economy vulnerable to uncontrolled inflationary pressures.

Economic Disruption: The Lack of a Remedy

A critical flaw in this scenario is the absence of the Federal Reserve's ability to tighten monetary policy. When an economy overheats, the Federal Reserve typically raises interest rates to reduce liquidity and cool down the economy. However, if it were the only buyer of Treasuries, it would be unable to perform this crucial function, rendering it powerless in the face of economic challenges.

Treasury-Starved Government: The inability to raise interest rates, coupled with the overdraft of the economy, would lead to unforeseen and severe consequences. Absent a buyer, the U.S. government would essentially be without cash, exacerbating existing economic issues and possibly endangering financial stability.

The Importance of Secured Investments and Market Stability

US Treasuries, recognized worldwide as the ultimate secure investment, play a pivotal role in maintaining economic stability. It is not simply a financial cushion for the U.S. government; it is an irreplaceable bulwark for the world economy. Figure 1 highlights the criticality of a stable market for such a secure asset.

Maintaining Market Function: The Fed's role in buying Treasuries mirrors the process of printing money, albeit without the physical currency. This practice injects more money into the system, leading to inflation when there is no corresponding increase in goods and services. However, it is important to understand that the primary goal is to maintain market function rather than arbitrary market removal.

Collapsing the Federal Reserve

Speculations about the collapse of the Federal Reserve under such an overwhelming pressure are unfounded. Instead, this question highlights the broader risks that such a scenario poses, including the destabilization of the global financial system. If the Fed were to take over the entire market alone, it would likely result in its own collapse, along with the broader economic context.

Regulatory and Market Stability: Moving away from the idea that the Fed could single-handedly bear the weight of the U.S. Treasury market underscores the importance of regulatory oversight and market stability. Corporate and individual investors provide legitimate demand for US Treasury bonds, which helps maintain market equilibrium. The Federal Reserve's role, in essence, is to ensure the smooth operation of these markets, not to dominate them exclusively.

Conclusion

The Federal Reserve plays a vital role in the economic landscape, particularly through its ability to manage inflation and liquidity. The scenario of the Federal Reserve being the sole buyer of US Treasuries exposes significant vulnerabilities and risks. Fiscal and monetary policies must remain balanced to ensure economic stability and avoid the disastrous consequences of unchecked inflation.