These Huge Deficits Wouldn’t Be Possible without the Fed’s Inflation
With the Federal Reserve’s annual Jackson Hole symposium there’s been much talk about when the central bank might allow interest rates to rise, presumably through the process of “tapering.” Tapering would mean easing monthly bond purchases, which would “effectively increase interest rates.“
Much of the discussion over the Fed’s policies on interest rates tends to focus on how interest rate policy fits within the Fed’s so-called dual mandate. That is, it is assumed that the Fed’s policy on interest rates is guided by concerns over either “stable prices” or “maximizing sustainable employment.”
This naïve view of Fed policy tends to ignore the political realities of interest rates as a key factor in the federal government’s rapidly growing deficit spending.
While it is no doubt very neat and tidy to think the Fed makes its policies based primarily on economic science, it’s more likely that what actually concerns the Fed in 2021 is facilitating deficit spending for Congress and the White House.
The politics of the situation—not to be confused with the economics of the situation—dictate that interest rates be kept low, and this suggests that the Fed will work to keep interest rates low even as price inflation rises and even if it looks like the economy is “overheating.” If we seek to understand the Fed’s interest rate policy, it thus may be most fruitful to look at spending policy on Capitol Hill rather than the arcane theories of Fed economists.
Why Politicians Need the Fed to Keep Deficit Spending Going—at Low Rates
If all this spending were just a matter of redistributing funds collected through taxation, that would be one thing. But the reality is more complicated than that. In 2020, the federal government spent $3.3 trillion more than it collected in taxes. That’s nearly double the $1.7 trillion deficit incurred at the height of the Great Recession bailouts. In 2020, the deficit is expected to top $3 trillion again.
In other words, the federal government needs to borrow a whole lot of money at unprecedented levels to fill that gap between tax revenue and what the Treasury actually spends.
Sure, the Congress could just raise taxes and avoid deficits, but politicians don’t like to do that. Raising taxes is sure to meet political opposition, and when government spending is closely tied to taxation, the taxpayers can more clearly see the true cost of government spending programs.
Deficit spending, on the other hand, is often more politically feasible for policymakers, because the true costs are moved into the future, or they are—as we will see below—hidden behind a veil of inflation.
That’s where the Federal Reserve comes in. Washington politicians need the Fed’s help to facilitate ever-greater amounts of deficit spending through the Fed’s purchases of government debt.
Without the Fed, More Debt Pushes up Interest Rates
When the Congress wants to engage in $3 trillion dollars of deficit spending, it must first issue $3 trillion dollars of government bonds.
That sounds easy enough, especially when interest rates are very low. After all, interest rates on government bonds are presently at incredibly low levels. Through most of 2020, for instance, the interest rate for the ten-year bond was under 1 percent, and the ten-year rate has been under 3 percent nearly all the time for the past decade.
But here’s the rub: larger and larger amounts put upward pressure on the interest rate—all else being equal. This is because if the US Treasury needs more and more people to buy up more and more debt, it’s going to have to raise the amount of money it pays out to investors.
Think of it this way: there are lots of places investors can put their money, but they’ll be willing to buy more government debt the more it pays out in yield (i.e., the interest rate). For example, if government debt w
Article from Mises Wire