DEEP DIVE: Fiscal Policy - A Trillion Here, a Trillion There

We have been on Wall Street as economists and strategists for more than 40 years. Over that entire period, doomsters have been scribbling away, producing lots of articles and books about the US federal deficits and debt. The only pause in their doom and gloom was during the late 1990s and early 2000s, when the federal government ran a surplus for a brief time. Nevertheless, while the annual federal deficits are now measured in trillions rather than billions, doomsday has yet to occur (Fig. 3).

Of course, as a result of the pandemic, the US budget deficit ballooned to record levels as government outlays soared, while receipts were depressed (Fig. 4). On a 12-month basis, the deficit hit a record $4.1 trillion during March 2021. It briefly fell just below $1.0 trillion during July 2022. In March of this year, it was back at $1.8 trillion, as outlays have been outpacing receipts.

There’s been one obvious adverse consequence of running such large deficits. The rebound in inflation since late 2021 undoubtedly was attributable to the three rounds of billions of dollars in pandemic relief checks sent by the government to millions of Americans in 2020 and 2021. All that fiscal stimulus combined with ultra-easy monetary policies amounted to “helicopter money,” a concept discussed by economist Milton Friedman and former Fed Chair Ben Bernanke. That money drop triggered a buying binge, mostly for goods since many services providers were hampered by social-distancing restrictions. The resulting demand shock overwhelmed global supply chains and sent inflation soaring.

But so far, the consequences of massive deficits haven’t been doomsday in nature. Nevertheless, it is hard to see how this doesn’t end badly eventually. There is a doomsday mechanism built into the government’s ever rising debt. The net interest paid by the government continues to grow rapidly, especially now that short-term interest rates have soared by 500bps over the past year. This outlay rose to a record $564.9 billion over the 12 months through March (Fig. 5). Just before the pandemic, it was $383.7 billion. However, the government's net interest outlays boost the income of investors who buy the government's securities at higher interest rates.

As Treasury issues mature and must be refinanced at higher interest rates, the government’s outlays on net interest paid will continue to rise. We estimate that the average interest rate paid by the Treasury on its publicly held debt is currently around 2.20% (Fig. 6). At 3.00%, the annual net interest expense would be $740 billion currently.

So why isn’t the deficit causing interest rates to soar? Consider the following:

(1) The Fed’s holdings of Treasury, agency, and mortgage-backed securities peaked at a record high of $8.5 trillion during May 18, 2022. As a result of the Fed’s quantitative tightening program, the Fed’s holdings of these securities are down $633.8 billion to $7.9 trillion as of April 19 (Fig. 7).

The comparable securities held by commercial banks peaked at a record $4.7 trillion on February 23, 2022. They are down $570.7 billion since then through April 12.