The Government Deficit and the Fed

The Federal Reserve recently announced an increase in the interest rate which it sets. This has implications for the government deficit which may not be well understood by the average person so I thought that it might make sense to discuss the connection between the Federal Reserve and the government deficit. What this discussion reveals is that the Fed has been helping to finance the government deficit in the U.S.

The Consolidated Government Budget Constraint

There is a relationship between the government and the Fed known as the Consolidated Government Budget Constraint that is written below.

Spending + Interest Payments + Net Transfer Payments =

Tax Receipts + Change in the Stock of Debt + Change in the Monetary Base

The items on the left side of the equal sign are the uses of the government’s funds. Spending refers to the fact that the government buys goods and services, it makes interest payments to the holders of government debt, and it makes transfer payments to individuals in the economy. The right side of the equation is the list of sources for the government’s spending. It receives tax payments, it issues or retires bonds, and the last item reflects bond purchases or sales by the Federal Reserve. It is these last two items that reflect the connection between the Fed and the government deficit.

Open Market Operations

When the Fed carries out an open market operation, it buys or sells bonds. When it does so, it can happen that the bonds issued by the government to finance its deficit are bought by the Fed using its open market operations. In this case, it is often said that the Fed “printed money” to finance the deficit but this is not strictly true. What happened is that the Fed created bank reserves (think of these as checking accounts that banks have with the Fed) when it bought the bonds. So when this happens, the Fed is financing part of the deficit but there is an additional aspect to this activity. The Fed earns interest on its bond holdings and it uses these revenues to finance its operations with the excess returned to the Treasury. Last year, it returned about $92 Billion to the Treasury.

Since the Fed has indicated that it intends to raise the interest rate that it sets, this means that they will be selling, not buying, government bonds. So for this reason, they will not be financing the deficit by purchasing more government debt. But in addition, its interest earnings will decline because they will hold fewer bonds. This fact implies that the funds returned to the Treasury will decline. The government deficit will thus be larger because of these reduced interest payments returned to the Treasury.

The big picture here is that the aging of the U.S. population will be driving up the government deficit and the Fed’s actions will further raise the deficit. These realities will create very serious problems for the President and Congress to address because they will be faced with the prospect of imposing substantial tax increases and/or spending reductions to avoid a debt crisis as entitlements spending rises substantially.