What will happen to the Fed if the national debt is paid off? Could the Fed buy precious paintings in the open market, instead of using Treasury debt to implement monetary policy?

Yours is a most timely question, one that is of particular interest to the Federal Reserve System!

Treasury Securities: Monetary Policy Tool

The Fed’s primary tool for implementing monetary policy is to buy and sell government securities in the open market. When the Fed buys (sells) U.S. Treasury securities, it increases (decreases) the volume of bank reserves held by depository institutions.1 By adding (subtracting) reserves the Fed can put downward (upward) pressure on the interest rate on federal funds – the market where banks buy and sell reserves, mostly on an overnight basis. For additional information this subject, you may wish to review the chapter on open market operations, in The Federal Reserve Systems Purposes and Functions. This publication is available online at: http://www.federalreserve.gov/pf/pf.htm.

Treasury Securities: Fed Portfolio

Not only do open market operations affect conditions in the federal funds market, they also affect the amount of U.S. Treasury debt the Federal Reserve holds. As of January 31, 2001, the Federal Reserve Banks held $516 billion dollars in U.S. Treasury securities. The Fed’s portfolio of Treasury debt is its primary source of income; it earned $32.7 billion in 2000. Approximately $25.3 billion of the Federal Reserve Banks’ income was distributed to the U.S. Treasury as interest on Federal Reserve Notes.2

What If?

If the U.S. Treasury were to pay off the national debt (see Dr. Econ, August 2000 answer, "What would be the likely effect of completely paying off the public debt?" /education/activities/drecon/2000/0009.html), then the Fed would have to acquire assets other than Treasury securities to hold in its portfolio. Is that possible? Again, let me quote from Purposes and Functions:

In theory, the Federal Reserve could provide or absorb bank reserves through market transactions in any type of asset. In practice, however, most types of assets cannot be traded readily enough to accommodate open market operations. For open market operations to work effectively, the Federal Reserve must be able to buy and sell quickly, at its own convenience, in whatever volume may be needed to keep the supply of (bank) reserves in line with prevailing (monetary) policy objectives. These conditions require that the instrument it buys or sells be traded in a broad, highly active market that can accommodate the transactions without distortions or disruptions to the market itself.3

So, while it might be possible in theory for the Fed to purchase precious paintings, it may not work well in practice.

Can the Fed Make Monetary Policy Without Treasury Debt?

While pondering your question, I came across a recent comment by Federal Reserve Board Chairman Alan Greenspan on this very subject. In a speech before the Bond Market Association on April 27, 2001, Chairman Greenspan said:

I am confident that U.S. financial markets, which are the most innovative and efficient in the world, can readily adapt to a paydown of Treasury debt by creating private alternatives with many of the attributes that market participants value in Treasury securities.4

Endnotes

1. The Federal Reserve System Purposes and Functions. (1994) Board of Governors of the Federal Reserve System, Washington, DC. See Open Market Operations, pages 34-42. http://www.federalreserve.gov/pf/pf.htm

2. Federal Reserve Press Release. “Reserve Bank Income for 2000.” Board of Governors of the Federal Reserve System, Release Date: January 18, 2001. http://www.federalreserve.gov/boarddocs/press/general/2001/20010118/default.htm

3. The Federal Reserve System Purposes and Functions, (1994), page 36.

4. “Greenspan Encourages Bond-Market Professionals To Prepare for World Without Government Debt.” Wall Street Journal, Gregory Zuckerman, April 30, 2001.

References

Akhtar, M.A. (1997) Understanding Open Market Operations. Federal Reserve Bank of New York, New York.

Greenspan, Alan. (2001) "The Paydown of Federal Debt." Presentation Before the Bond Market Association, White Sulphur Springs, West Virginia (via videoconference), April 27, 2001.
http://www.federalreserve.gov/boarddocs/speeches/2001/20010427/default.htm

Federal Reserve Bulletin. (2001) Board of Governors of the Federal Reserve System, April 2001, Table 1.18, Federal Reserve Banks, page A10.

Federal Reserve Press Release. "Reserve Bank Income for 2000." Board of Governors of the Federal Reserve System, Release Date: January 18, 2001.

The Federal Reserve System Purposes and Functions. (1994) Board of Governors of the Federal Reserve System, Washington, DC. See Open Market Operations, pages 34-42. http://www.federalreserve.gov/pf/pf.htm

Zuckerman, Gregory. (2001) "Greenspan Encourages Bond-Market Professionals to Prepare for World Without Government Debt." Wall Street Journal, April 30, 2001.