The Federal Reserve’s belated campaign to curb surging inflation is aimed at reducing the excess of demand over achievable supply, and thereby ease price pressures. The end of the easy-money era, if in fact that is what is now afoot, will have big effects not only on the economy but also on the policy environment. Among other things, the government’s already adverse fiscal position will get worse—possibly much worse.
For the moment, the coming turn in fortunes for the government’s coffers is not yet in view, and may not be for a year or two. The current data point in the opposite direction, toward a rather remarkable improvement in the government’s borrowing needs in recent months, which is something the Biden administration has been touting to no discernible political effect. Through May (seven months into the fiscal year), the federal government has run a cumulative budget deficit for 2022 of $0.426 trillion. That’s a fall of over $1.6 trillion compared to the first seven months of fiscal year 2021.
The improvement has been so dramatic that the Congressional Budget Office (CBO) has revised its 2022 forecast. It now says that the full-year deficit in 2022 will be about $1.0 trillion, or, when expressed relative to GDP, about 4.0 percent. That would be high by postwar standards but in line with the experience during the years immediately preceding COVID-19. CBO’s current estimate for the 2022 deficit is about $150 billion below its forecast from nearly one year ago.
A major factor is surging federal receipts. So far in 2022, federal tax collections are up 29 percent compared to 2021. Individual income taxes alone are up $610 billion, an increase of 46 percent compared to 2021. Some of the jump is a timing shift; a provision in one of the COVID-19 response bills allowed employers to delay certain tax payments, which shifted revenue from 2021 into 2022. However, not all of the increase can be explained by a delay in payments, which means some of the jump is likely due to strong economic conditions, including surging wages and asset prices.
Outlays have fallen dramatically too as federal support provided to cushion the economy during the pandemic is withdrawn. Overall, through May, federal spending is down 19 percent compared to 2021, with much of the drop concentrated in the accounts that provided refundable tax credits for many millions of taxpayers (which often counts as new spending, and not tax cuts) and support for businesses to discourage layoffs.
While these trends have provided a welcome improvement in the near-term budget outlook, the ground is now shifting. Tighter monetary policy will affect budget totals in two important ways.
First, since 2008, the Fed has been the largest purchaser of Treasury-issued debt instruments. Over the period 2008 to 2021, the federal government borrowed an additional $16.5 trillion, with the Fed buying nearly $5.0 trillion of the newly issued Treasury debt. The funds for this lending by the Fed came from expansion of the money supply—so-called “quantitative easing.”
The Fed now plans to unwind some of these holdings through a policy of “quantitative tightening,” which means the proceeds from a portion of the maturing securities will not be reinvested in new Treasury issuances. The practical effect of this reversal will be to force the Treasury to borrow much more from non-Fed creditors.
In CBO’s most recent forecast, the Fed is expected reduce the amount of Treasury debt it owns by $2.2 trillion over the period 2022 to 2025. As a consequence, the Treasury will need to borrow about $5.6 trillion in public markets in that period to cover both the government’s ongoing annual deficits ($3.4 trillion for 2023 through 2025) and pay down some of the debt it previously borrowed from the Fed.
The effect of quantitative tightening on interest rates is difficult to predict but it certainly won’t contribute to keeping them down. Demand for Treasury debt is high but has a limit too. At some point, those lending money to the U.S. government may want to earn a better return on the funds they are providing, which could increase federal borrowing costs.
The second effect of tighter money on the budget will be more direct. The Fed’s policy of raising the federal funds rate is sure to push up interest rates on Treasury securities. In CBO’s updated baseline, the agency projects the interest rate on 10-year Treasury notes will increase from 1.4 percent in 2021 to 2.4 percent in 2022 and 2.9 percent in 2023. Currently, the rate is already well over 3.0 percent, and rising. With further increases in the federal funds rate expected through the summer months, it is unlikely that CBO’s assumptions will prove to be accurate.
Rising net interest expenses for the government will have a noticeable effect on the government’s borrowing requirements. CBO built an interactive workbook that allows for user-specified alterations to certain economic assumptions, including interest rates. If the interest rate for 10-year notes is a half percentage point higher in 2022 than assumed by CBO, and 1.0 percentage point higher each year over the period 2023 to 2032, the federal government will borrow an additional $2.7 trillion over the coming decade compared to the agency’s current forecast. By 2032, federal debt will reach nearly $43 trillion, or the equivalent of 117 percent of annual GDP.
The degree of uncertainty over the future course of the economy and fiscal aggregates is exceptionally high at the moment, owing to the volatile global environment. It is possible that price pressures from the energy sector will ease in the coming months—or get worse. It is also possible that aggressive monetary tightening will trigger a recession that necessitates yet another reversal in policy.
Even so, the current moment does seem destined to mark a turning point. Since 2007, the Fed has pursued an exceptionally accommodating monetary policy. Borrowing has never been so inexpensive, with all that has meant for financial markets. It had to end at some point, and, as it does, many institutions will need to adjust, including the U.S. Treasury.