The Federal Reserve and the National Debt

Jerome Powell
Jerome Powell (Wikipedia)

The Federal Reserve System (“the Fed”) was established by Congress in 1913, and its Board of Governors is appointed by the President, but it’s an independent central banking system and not really part of the federal government. One of its primary jobs is to administer the nation’s monetary policy, with the objectives of maximum employment, stable prices, and moderate long-term interest rates.

The Fed’s primary tool for implementing monetary policy is the purchase and sale of short-term U.S. government bonds on the open market. When they want to lower interest rates to stimulate the economy they buy bonds and, in effect, print new money to pay for them. This increases the money supply so interest rates go down because the law of supply and demand applies to the price of borrowing money too. Conversely, when the Fed wants to cool off the economy to keep inflation in check, they sell bonds, thereby collecting money from the economy and reducing its supply, making it more expensive through higher interest rates. (Gold has nothing to do with the nation’s money supply. Gold isn’t money.)

The Fed’s Open Market Committee (FOMC) manages these bond transactions by identifying a target for the federal funds interest rate, which is the rate that banks pay to lend to each other. The Fed can’t actually set any interest rates, it can only set target rates and try to bring them about through its bond transactions.

In order to stimulate the economy in response to the Great Recession, the FOMC reduced its target for the federal funds rate to an unprecedented low of nearly zero in December 2008. The crooks on Wall Street, however, had destroyed so much wealth during the Bush administration that the FOMC took another unprecedented step by initiating large-scale asset purchases (LSAPs) to increase the money supply even further. These open market purchases, known as quantitative easing (QE), were made up of longer-term U.S. government bonds and longer-term mortgage-backed securities from the government-sponsored agencies Fannie Mae or Freddie Mac.

The historically low interest rates created by the Fed’s recent actions have created some economic anomalies, but they’ve certainly helped the U.S. economy to recover. The Fed’s long-term strategy, obviously, is to “taper” their bond purchases so that interest rates can eventually be normalized and rise to historical averages. It’s a tricky task because they could stall the economic recovery by decreasing the money supply too soon. They are using economic data to determine the best strategy, and have identified the unemployment rate as their primary indicator. Their focus on the unemployment rate, however, is problematic because ongoing structural changes in the U.S. economy have rendered one third of the current job seekers unemployable because the jobs they used to perform are obsolete and gone forever.

So, what does all of this have to do with the national debt, if anything? The U.S. government finances the debt created by the spending that’s approved by Congress and the President through the issuance of U.S. Treasury bonds – the bonds that the Fed purchases and sells to alter the money supply and manage interest rates.

But despite a record national debt of about $12 trillion at the end of 2013, the cost to the Treasury of paying interest on it has actually decreased since 2008 because of the historically low interest rates implemented by the Fed. Additionally, since 2010 the Treasury has been paying negative real interest rates on government debt because the inflation rate has exceeded interest rates.

This doesn’t mean, however, that the interest payments on the national debt are insignificant. According to the Congressional Budget Office, the net interest paid on the federal debt in FY2012 was about $220 billion and was projected to be about $223 billion in FY2013, or about 6% of the total federal budget. It’s a small amount in relative terms, but it still exceeds the budgets of many government programs. The National Park Service’s budget, for example, was only about $3 billion in FY2012, and NASA’s FY2012 budget was only about $19 billion. Furthermore, about 40% of these interest payments are sent overseas to foreign holders of U.S. bonds, especially China.

When the Fed decides the time is right to raise interest rates, the cost of paying interest on the national debt will rise considerably. Some estimates show normalized interest rates will result in interest payments on the national debt increasing to $1 trillion annually. This will create difficult choices, as less money will available for important government programs, including Social Security and Medicare.

The obvious solution is for Congress and the President to reduce the federal government’s debt. Most agree this must be done through a gradually implemented mixture of reduced spending and increased taxes, as simply making large cuts in government spending would send the economy into another recession. But getting Democrats and Republicans to agree on an acceptable combination has been difficult. It was made even more so by the recent strategy of right-wing Tea Party Republicans in the U.S. House of Representatives. In the fall of 2013 they created a government shutdown when they held the annual budget appropriations bills and a routine increase in the federal debt ceiling hostage in exchange for cuts in government spending and the enactment of some of their domestic policies. In the end, however, they had to back down from their radical strategy of political brinkmanship as public opinion turned against them.

We Have to Trust That the Federal Reserve Will Get it Right

So the bottom line is that the Fed’s Board of Governors, led by their newly appointed Chairperson Janet Yellen, will have some tough decisions to make in the next few years. They must figure out when the time is right to start normalizing interest rates. If they increase interest rates too quickly it could throw the economy into another recession, but if they do it too slowly it could lead to high inflation. And at the same time they must also consider that interest rate increases could significantly increase the federal debt. Many people are skeptical they can succeed in this high-wire balancing act, but they are very smart and experienced money professionals. We have few options but to trust they’ll get it right. A bigger danger might be that they have no more bullets in their gun if another economic calamity occurs before interest rates are normalized.

Updates

On November 2, 2017, President Donald Trump nominated Jerome Powell to be the next chair of the Federal Reserve, replacing Janet Yellen.

On January 23, 2018, Powell was confirmed by the U.S. Senate by a 84–13 vote, and assumed office as the Fed Chair on February 5, 2018.

On July 20, 2018, Pres. Donald Trump criticized the Federal Reserve’s monetary policy of gradually normalizing interest rates. In a Tweet he complained that, “Tightening now hurts all that we have done.” He said he was concerned that rising interest rates would make the unprecedented government borrowing created by his 2017 Tax Cuts and Jobs Act too expensive.

On October 11, 2018, Pres. Trump complained that the Federal Reserve “is going loco” by continuing to gradually increase interest rates after the U.S. stock market’s Dow Jones Industrial Average dropped by more than 800 points the day before. Interest rates, however, still remained well below historic averages.

On February 13, 2019, the U.S. Treasury Department reported that the U.S. government’s public debt had accumulated to an all time record of $22 trillion.

On March 9, 2019, Pres. Trump tweeted that the Fed had “mistakenly raised interest rates” and that U.S. GDP and stock prices “would have both been much higher” if they hadn’t continued to raise the rates.

On March 20, 2019, The Federal Reserve announced it wasn’t raising interest rates in 2019, citing a number of economic risks due to a domestic and global slowdown.

On July 11, 2019, Fed chief Jerome Powell hinted to Congress that an interest rate cut was coming to cushion the economic difficulties created by Trump’s trade wars.

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