The Federal Reserve has a dual mandate from Congress: price stability and maximum employment. Nowhere is it written that it’s the Fed’s job to provide cheap money for the federal government to spend, but that’s precisely the hole the Fed has dug for itself. Digging out of that hole will be painful.
From its inception in 1913, the Federal Reserve took nearly a century to acquire a $900 billion balance sheet. In response to the Great Recession, it went on a “quantitative easing,” or QE, binge. Between 2009 and now, it bought bonds and more bonds, mostly U.S. Treasury debt, with newly created money. The Fed’s balance sheet ballooned to over $4 trillion. That’s trillion.
This balance sheet blowout had two consequences. One was artificially ultra-low interest rates. All that extra demand for Treasury debt drove bond prices up and interest rates down. Second, the Fed itself became a source of cheap federal financing. Not only was the Treasury paying super-low rates to borrow money; at times during QE, the Fed was buying almost all of the net new federal debt. In effect, the Fed was printing money to cover the deficit. No need to pay attention to those messy private-sector buyers when you can peddle your bonds to your own central bank.
Think of negotiating a loan deal with your dog.
Like all things too good to be true, this sweet deal couldn’t go on forever. The Fed ended its QE program in late 2014. Last December, it took its first baby step toward returning interest rates to more normal levels by raising its target rate for overnight bank loans (federal funds) by 1/4 point.
Consider, however, what happens to the federal deficit if the Fed fully normalizes interest rates over the next several years. The following is a crude calculation, but it illustrates the box the Fed is in. Federal debt is roughly $19 trillion. Interest rates on federal debt are roughly 3 percent below historical averages. Average maturity of the federal debt is roughly four years. Do the math: $19 trillion x 0.03 = $540 billion.
If the Fed “normalizes” interest rates, within four years, increased interest expense will add $540 billion a year to the federal deficit. That’s almost exactly the budget for the entire Department of Defense.
Fed officials don’t talk much about this elephant in the room. But you can bet they know it’s there.•
Bohanon is a professor of economics at Ball State University. Styring is an economist and independent researcher. Both also blog at INforefront.com. Send comments to firstname.lastname@example.org.