The two largest holders of federal debt are the Fed and the Social Security trust. A big part of the reason interest rates are so low is because we're buying our own debt.
Neither participates in the competitive bidding process that sets the interest rates. Social Security gets special bonds not available on the open market, and the Fed buys Treasuries from primary dealers at market rates (since the whole point is to inject money into the private economy).
Replying to myself since I can't reply directly to you.
Social Security gets special bonds specifically to avoid the bond market distortions you describe. They have been purchasing these bonds in high volume for decades prior to the financial crisis, and marketable Treasury rates were much higher for most of that time.
In addition, in 2011, SS tax receipts dropped below expenditures for the first time since 1983, so SS stopped purchasing these special bonds in any significant net volume. (The trust fund is still cash flow positive due to interest earned on bonds they already hold.)
As for the Fed's purchasing program, Treasury rates were historically low before Fed started buying. In fact the historically low rates were why they started buying Treasuries in the first place--with interest rates bottomed out, QE was one of the only levers left to them. You've got the cause and effect backwards.
I'm not trying to be an ass, but I'm actually legitimately curious where our misunderstanding is.
My understanding is that, all other things being equal, when government/government controlled agencies purchase government debt ("cause"), the result ("effect") is lower interest rates. Here it is, directly from the head of the Fed regarding the rationale behind QE2:
"What we're doing is lowering interest rates by buying treasury securities and, by lowering interest rates, we hope to stimulate the economy to grow faster." - Ben Bernake
This is the fundamental idea behind reserve banking -- the central bank controls interest rates by manipulating the money supply via the purchase of government bonds:
"When the Central Bank cuts the target rate, they must simultaneously increase the monetary base by buying government securities. The growth of the monetary base creates a surplus in the banks, the supply of funds overnight increases, the demand falls and the overnight rate falls.
...
By controlling overnight interest rates, the central bank will affect the interest rates with longer maturity." - Essentials of Macroeconomics
Is there anything in the above that you disagree with?
The Fed is using quantitative easing to lower market interest rates because their typical lever against market interest rates--the interest rates of short-term U.S. Treasuries--was already effectively zero.
They were already effectively zero because there has been such strong demand for U.S. Treasury bonds from customers both domestic and foreign, which was my point at the beginning.
It doesn't matter how the bonds are obtained by Social Security or the Fed -- no matter what it affects interest rates.
If Social Security weren't buying government bonds (ok, not technically treasuries), that same debt would be issued as Treasuries or similar. Greater supply of treasuries means higher interest rates.
If the Fed weren't buying treasuries in the open market, demand would decline and the market interest rate would go up. Primary dealer bids are influenced by the market rate for treasuries, so the interest rate on new debt would go up.
