The Role of the Federal Reserve
The Federal Reserve (“the Fed”) is the central bank of the United States. Its principal role is to foster an economy with maximum employment and stable prices via monetary policy. The Fed has historically accomplished this by influencing the federal funds rate (FFR), which is essentially the interest rate that banks charge other banks to lend cash overnight. The FFR is considered the benchmark for short-term loans, and it influences the interest rates for Treasuries, mortgages, and other long-term loans and bonds.
In recent years, the Fed has begun to also use quantitative easing (QE) to implement its monetary policy objectives.
When Regular Monetary Tools Aren’t Enough
Traditional monetary policy holds that the Fed can stimulate economic demand during a downturn by reducing the federal funds rate, and therefore the opportunity cost of spending and investment in the broader economy. If interest rates are low, people are more willing to invest in the economy and buy things, stimulating demand and economic growth. But what happens when the FFR is already close to zero?
During the 2008 financial crisis the Fed reduced the federal funds rate close to zero, but it felt this wasn’t a sufficient response. The Fed began purchasing U.S. Treasury debt, mortgage-backed securities (MBS), and agency debt to further stimulate economic demand by artificially lowering borrowing costs on long-term loans.
To purchase these securities, the Fed primarily issued new bank reserves; in effect, the Fed “printed” money to buy them from primary dealers (large financial institutions). This unusual monetary policy action is referred to as quantitative easing (QE).
Historical Use of Quantitative Easing
Beginning in late 2008, the Fed entered several periods of QE, with the balance sheet growing to $4.5 trillion of assets in early 2015. From 2017 to 2019, the Fed modestly reduced the quantity of assets it held by not replacing them as they matured, starting a period of quantitative tightening (QT).
The COVID-19 pandemic once again prompted the Fed to purchase significant amounts of Treasuries and later MBS. In May 2020, it owned $4.1 trillion in Treasuries, or 21% of the federal government’s debt at the time. Total assets peaked at almost $9 trillion in April 2022. After that peak, the Fed entered another period of QT, reducing its assets by more than $2.4 trillion dollars. Fed assets totaled about $6.5 trillion by the end of 2025.
In December 2025, the Fed announced that it would start purchasing $40 billion a month in Treasuries, reversing their previous policy of QT.
Distorting Markets
By artificially lowering interest rates using QE, especially on Treasuries, the Fed distorts the market for public debt. For example, the higher the government’s debt is relative to its capacity to pay back that debt, the higher the rate of interest the market will demand to loan money to the government. This market signal would make the government hesitant to take on too much debt that it could not afford to pay back.
QE mutes this signal, making government debt cheaper than it otherwise would have been, and making it easier for the government to take on unsustainable amounts of debt. With the national debt at over $38 trillion, interest costs to service that debt are quickly becoming one of the largest spending items in the federal budget. Even small changes to the interest rate on the debt can have an outsized effect on the budget.
The larger the debt becomes, the more likely the Fed will have to continue QE just to keep the government solvent and prevent a fiscal crisis. The Fed would have its monetary policy dictated by the federal government’s fiscal policy, which would undermine its status as an independent institution. And once the markets believe the Fed has lost its independence, they would lose faith that the Fed will maintain stable prices, which could lead to economic instability.
Another concern regarding market distortions is Section 13(3) of the Federal Reserve Act. This section grants the Fed the power to provide liquidity to systemically important financial and non-financial institutions during “unusual and exigent circumstances,” where the collapse of such institutions could endanger the health of the economy. This creates a moral hazard, because institutions and markets will make riskier investment decisions if they believe they would be bailed out by the Fed with its Section 13(3) powers and QE.
