Concerns About Feds Raising Interest Rates

Dated: 12/15/2015

Views: 338

Raising borrowing costs would mean a larger interest burden for the U.S. government.

Since the release last week of the latest monthly U.S. jobs report, the positive numbers have many wondering if theFederal Reserve will start raising short-term interest rates as early as June.

The central bank may offer more clues when officials meet next week. If the Fed chooses to raise rates soon, it would easily add between $1 trillion to more than $2 trillion to America’s debt over the next decade, compared to a scenario in which rates remain low.

How? This can happen in three ways: The first and most obvious channel is that higher borrowing costs will mean a larger interest burden for the federal government. Icalculated that the path of interest rate hikes projected by the Congressional Budget Office (CBO) could add almost $2.9 trillion to U.S. debt over the next 10 years, compared with a scenario where interest rates stayed where they are today. Even splitting the difference between the current near zero rates and the 3% rate projected by the CBO would still save the government more than $1.4 trillion, and leave us with a lower debt-to-GDP ratio in 2025 than we have now.

Secondly, the CBO assumes that as part of its tightening, the Fed will sell off the assets it purchased through its various large-scale bond purchasing programs, called quantitative easing. Under QE, the Fed purchased more than $3 trillion of mortgage-backed securities and long-term debt as part of an effort to keep rates low and stimulate the economy. The interest from these assets increased Fed earnings, and consequently, the Fed’s refunds to Treasury (after paying its operating fees and member banks, the Fed refunds the rest of its earnings to the U.S. government via the Department of the Treasury).

The CBO assumes that the Fed will want to quickly sell off the bonds purchased through QE to put upward pressure on interest rates and avoid over-stimulating the economy. But if the Fed sees no need to put the brakes on the economy and continue to hold the same amount of bonds over the next decade as it does today, it would gain an additional $600 billion in interest compared to the CBO baseline. Even an intermediate path would generate more than $300 billion more in income from interest.
Since raising interest rates would also slow the economy’s growth it would also keep unemployment from declining further. Although this isn’t generally recognized, the budget surplus during the Clinton years in the 1990s was largely due to low unemployment. In 1996, the CBO expected a large budget deficit for fiscal year 2000. However, by keeping interest rates low, the economy grew much faster than officials expected. The CBO had projected the unemployment rate would be 6% in 2000; instead it averaged just 4% for the year.

The same logic applies today. If the Fed allows the economy to grow more and the unemployment rate to fall further the government could collect more in tax revenue and pay out less money in unemployment insurance and other benefits. A scenario in which the economy can sustain a 4% unemployment rate, as opposed to the 5.4% rate projected by the CBO in the years after 2016 would lead to cumulative budget savings of more than $1.8 trillion over the decade. In this case, the debt–to-GDP ratio would be more than 5 percentage points of GDP lower in 2025 than it is today.

We would not want the Fed to make bad choices on monetary policy for the purpose of reducing the budget deficit, but in a context where the case for interest rate hikes is ambiguous, it is reasonable to take the budgetary impact into account. Lower interest rates from the Fed is a much easier way to reducing the deficit than tax increases or budget cuts.

Dean Baker is a macroeconomist and co-director of the Center for Economic and Policy Research in Washington, DC. He previously worked as a senior economist at the Economic Policy Institute and an assistant professor at Bucknell University.

Watch more business news from Fortune:

Blog author image

Carl Ballard

Carl Ballard has resided in the Denver Metro area for over 30 years. His family has worked in the Denver Metro real estate market for over 25 years. Carl has vast knowledge and familiarity with the re....

Latest Blog Posts

Your First Step in Buying a Home

Pre-ApprovaL:YOUR 1st Step In Buying A HomeIn many markets across the country, the number of buyers searching for their dream homes outnumbers the number of homes for sale. This has led to

Read More

Your First Step in Buying a Home!

In many markets across the country, the number of buyers searching for their dream homes outnumbers the number of homes for sale. This has led to a competitive marketplace where buyers often

Read More

New Listing - Denver - Under $175,000

You will fall in love with this 2 bedroom condo located at5995 W Hampden Avenue, H14 in Denver.   Centrally locatedoff of Hampden between Sheridan and Wadsworth. This home has been

Read More

7 Signals The Home You Are Looking At Will Have a Solid Resale Value

While it might seem premature to think about selling a home before you even buy it, it's important to remember that a house is an investment. And in an ideal world, investments make&

Read More