Fed Tightening Will Have a Fiscal Effect

Now that the cognescenti have judged that goods/services price inflation has transitioned from transitory to something more persistent, the Fed has signaled that it is ready to start raising its main policy interest rate, the federal funds rate, at the mid March FOMC meeting. Moreover, the Fed has suggested that a March interest rate hike will be one of several this year. By how many basis points will the Fed raise the federal funds rate this year from its current level of 0.08%? No one knows, especially the Fed. The federal funds futures market is currently priced to suggest a cumulative 150 basis point rise in the federal funds rate over the next 12 months. But just as Fed policy is "data dependent", so is the federal funds futures market. However many basis points the Fed raises the federal funds rate over the next year, it will have a fiscal effect. That is, it will contribute to an increase in federal outlays in the form of higher net interest payments. Higher Treasury debt-servicing expenses imply higher future federal budget deficits, all else the same.

The blue bars in Chart 1 are the fiscal year values of Treasury net interest expenditures as a percent of total federal outlays. The blue bars in the shaded area from fiscal year 2022 through 2031 are baseline forecasts made by the Congressional Budget Office (CBO) in July 2021. CBO baseline projections of budgetary variables incorporate current laws pertaining to the federal budget and the CBO's estimate of economic variables that would have an impact on budgetary variables. Also plotted in Chart 1 are the actual and CBO-forecast fiscal year average values of interest rates for the three-month Treasury bill (the green line) and the 10-year Treasury note (the red line). In FY 2021, Treasury interest expense as a percent of total federal outlays was 4.8% -- the lowest percentage in the period starting FY 1965. Given that federal debt held by the public increased by $6.2 trillion in the two fiscal years ended 2021, this low ratio of Treasury debt service expense relative to total federal outlays is remarkable. Of course, extremely low interest rates on Treasury debt played a major role in reducing debt-servicing costs relative to total federal outlays. More on this in a moment.

Chart 1

Notice that the debt service-to-total federal expenditures ratio trends up after FY 2021 in the CBO's baseline forecast, reaching 11.6% by FY 2031, the highest since FY 2000. The rise in this debt-service ratio is the result of a forecast gentle rise in interest rates and a cumulative $12.8 trillion increase in the Treasury debt held by the public in the 10 fiscal years ended 2031 (not shown).

If, perchance, interest rates were to move higher and sooner than the CBO has forecast, all else the same, the debt-service ratio would also move higher than forecast. And, given the Fed's rhetoric about beginning to hike the federal funds rate in mid March, it would appear that interest rates will move higher and sooner than than the CBO's forecast. The blue and red lines on the left-hand side of Chart 2 are the weekly averages of the actual three-month Treasury bill and 10-year Treasury note interest rates, respectively, through the week ended February 11, 2022. The green and black bars in Chart 2 are the fiscal year CBO-forecasts of three-month Treasury bill and 10-year Treasury note interest rates, respectively, for fiscal years 2022 , 2023 and 2024. In the week ended February 11, 2022, the three-month Treasury bill interest rate averaged 0.31%; the 10-year Treasury note interest rate averaged 1.95%. The 1.95% yield on the 10-year Treasury note is just 5 basis points above the CBO forecast for FY 2022 and 5 basis under the CBO forecast for FY 2023. But the 0.31% yield on three-month Treasury bill is 24 basis points above the CBO forecast for FY 2022 and 13 basis points above the CBO forecast for FY 2023. Moreover, the fed funds futures market as of the week ended February 11, 2022 was forecasting a federal funds rate of 1.66% 12 months hence. Given that the rate on three-month Treasury bills tends to trade about 18 basis points under the federal funds rate, this would imply a three-month Treasury bill interest rate of 1.48% in about a year. The CBO baseline forecast does not have the three-month Treasury bill interest rate rising to this level until FY 2027. The upshot of this is that the July 2021 CBO baseline forecast of the ratio of Treasury interest costs to total federal expenditures is too low.

Chart 2

Let's do some back of the envelope calculations, the only type I am capable of. At the end of FY 2022, Treasury debt held by the public is forecast by the CBO to be $24,392 billion and total net interest paid by the Treasury that year is forecast to be $306 billion. If my arithmetic is correct, that works out to be an effective interest rate on the publicly-held debt of 1.25%. What would the interest expense on this same amount of debt rise to if the interest rate on the debt increased by 50 basis points to 1.75%? $427 billion or $121 billion more than forecast. For FY 2023, the CBO is forecasting debt held by the public of $25,156, net interest payments of $315 billion, which works out to an effective interest rate on the debt of, again, 1.25%. What would the interest expense on this same amount of debt rise to if the interest on the debt in FY 2023 were 2.25%? $566 billion, or $251 billion higher than forecast. So, we have a cumulative increase in net interest expense in the two fiscal years ended 2023 of $372 billion above what is forecast. By the way, these calulations understate the net interest expenses in FY 2022 and 2023 because the amount of debt held by the public would be higher than forecast due to the issuance of additional debt to finance higher net interest payments. Do you think it is unreasonable to expect the effective interest rate on the debt held by the public to be a 100 basis points higher by September 30, 2023? I don't. I repeat, the upshot of this is that the July 2021 CBO baseline forecast of the ratio of Treasury interest costs to total federal expenditures is too low.

Plotted in Chart 3 are the actual and CBO-forecast major components of federal outlays as a percent of total outlays – net interest (blue line), discretionary (red line) and mandatory (green line). Net interest is self explanatory. Mandatory is dominated by Social Security, Medicare and Medicaid expenditures. Discretionary includes defense, infrastructure and the salaries of employees and equipment to run the various federal government departments. The share of mandatory expenditures remains steady around 64% to 65% in the forecast period. As previously mentioned, the share of net interest rises from 4.8% in FY 2021 to 11.6% in FY 2031. And discretionary expenditures rise from a share of 24.1% in FY2021 to about 30% in FY 2022 and 2023, then declines back to 24% by FY 2031. If the CBO's forecast of net interst expenses is too low, which it currently appears to be so, and if the CBO's forecast of total expenditures is near the mark, then the share of discretionary expenditures, which, again, includes defense expenditures, must decrease. In other words, net interest expenditures will "crowd out" discretionary spending.

Chart 3

With Russia becoming more of a geopolitcal mischief maker and China becoming a more formidable rival, it is likely that growth in nominal defense spending is going to grow faster over the next 10 years than the compound annual rate of about 2-1/4% forecast by the CBO in February 2021. Unless more is squeezed out of other discretionary spending, growth in total federal outlays is going to be higher than currently forecast. Unless taxes are raised (fat chance), this implies that the federal budget deficits are going to be higher than currently forecast. And, with the Fed raising the federal funds rate, net interest expenditures will further add to the deficits going forward. Of course, the Fed could restrain its federal funds rate hikes in order to lessen the impact of higher net interest expenses on total federal outlays. The Modern(?) Monetary Theorists(?) correctly tell us that a nation need not default on its public debt so long as that debt is denominated in the nation's currency, which the nation's central bank can create out of thin air. But is higher inflation just another word for default?

Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.