The federal government is skirting dangerous shoals with an irresponsible fiscal policy. We are running massive budget deficits in a booming peacetime economy. These deficits are increasing our federal debt—which means we are also paying more to service the debt and more interest on every dollar of debt. While the Federal Reserve has been covering a significant portion of those servicing costs since the debt started ballooning in 2007, Fed revenues are declining, so it won’t be able to shoulder as much of that burden. The result will be more pressure on Congress to put our fiscal house in order.
It is not widely recognized that the Fed is a source of federal government revenue. The Fed creates money and uses that money to purchase assets, typically government bonds. These assets earn interest, generating revenue for the Fed. After paying its expenses, the Fed returns the remainder of its revenues to the U.S. Treasury, which has been used to service the federal debt. In 2006, prior to the financial crisis and the Great Recession, the Fed held assets of $873.4 billion and had relatively few actual liabilities. That year, the Fed’s interest earnings were $36.8 billion and interest expenses were $1.3 billion. After paying operating expenses, the Fed returned $29.1 billion to the Treasury.
In the aftermath of the Great Recession several changes occurred. First, the Fed greatly expanded both the assets and liabilities on its balance sheet. In doing so, it created an equally large amount of funds in the form of either reserves or currency. Second, in order to keep the money supply from expanding proportionally with the increase in assets—that is, in order to keep inflation in check—the Fed began for the first time to pay interest on bank reserves. The Fed did this to give banks an incentive to hold part of the newly issued funds as bank reserves in lieu of putting these funds into circulation. Third, because the interest rate on Fed assets was greater than the interest rate on these bank reserves, the interest earned on the increase in Fed assets exceeded the interest it paid on the higher bank reserves.
The net effect was a large increase in both Fed net revenue and, therefore, in Fed payments to the Treasury. In fact, by 2010, the Fed was financing 39% of the interest cost of the Federal debt—and such high levels of financing continued through 2016, when Fed transfers to the Treasury reached $100 billion and covered 48% of the interest cost of the debt. But since 2016, the Fed has been covering less of that cost. In fiscal year 2018, the debt service cost was $322 billion and Fed transfers are projected to be $60 billion, or only 21% of the debt servicing cost. The Congressional Budget Office projects that by 2019, Fed transfers will cover only 11% of debt servicing cost—and by 2020, that the Fed will cover less than 10% of a debt service cost of $485 billion. This decline is dramatic: in a mere four years, the Fed will move from covering half of the debt servicing cost and one quarter of the deficit to under 10% of debt servicing and 5% of the deficit.
What is behind this decline in the Fed’s contribution to the Treasury?
First, it’s important to understand why interest payments are rising. As mentioned, as the federal debt grows, the cost of servicing it for a given interest rate also grows. Another reason is that the interest rate on government bonds was unusually low in the aftermath of the financial crisis, but has now returned to more typical levels, meaning that newly issued debt now incurs a higher interest rate than it did before. Further, some portion of the outstanding debt matures each year and is rolled over by the Treasury into new debt, and this new debt is refinanced at current, higher interest rates.
But why are the Fed’s contributions falling so dramatically? Fed earnings are tied to the difference between the interest earned on its assets and the interest paid on its liabilities (i.e. bank reserves). The Fed’s assets are mostly comprised of long-term securities for which the interest payments were set on their issue date. As long-term interest rates rise and existing securities mature, the Fed replaces them with securities paying the higher interest rate. So, the rise in rates affects the Fed’s earnings, but with a long lag.
In contrast, in order to maintain control of the money supply, the Fed must quickly raise the short-term interest rate it pays on bank reserves. To make matters worse, short-term rates are rising faster than long-term rates, and the interest rate the Fed pays on reserves is rising faster than interest rates in general. For example, just a year ago, the difference between 10-year and 1-year Treasuries was 100 basis points, a full percentage point. Now this difference has fallen in half to 50 basis points, or one-half of a percentage point—and interest earnings of the Fed have grown slower than interest expenses. Together, these factors reduce the Fed’s net earnings available for payment to the Treasury.
What does this mean for U.S. fiscal policy? To put it mildly, we are entering a period of significant budgetary headwinds. The deficit and the cost of servicing the debt now take up more than half of all federal income tax revenue. The days of the Treasury counting on the Fed to help out with government finances are coming rapidly to a close, and the full bill for our fiscal policy choices is coming due.
