The Fed and Fiscal Policy During the Obama Years
The federal government has run massive deficits since President Obama became president in 2009, but the deficits, and the government's interest payments on the cumulative federal debt, would have been even greater if the Federal Reserve had not intervened with a massive and unprecedented bond and securities buying program.
Beginning in 2009, the Fed began its multi-stage program of quantitative easing through large-scale purchases of Treasury and other securities. In the aftermath of the financial crash, the agency had quickly lowered the targeted federal funds rate to between zero and 0.25 percent. In early 2009, the bank's leaders, especially Ben Bernanke, sought to provide further monetary stimulus to the national economy and settled on large-scale asset purchases as the most viable way to expand the monetary base with interest rates already at the lower bound.
As of September 2008, the Fed held $477 billion in federally-issued debt, out of a cumulative total of $5.8 trillion. Thus, the Fed owned about 8 percent of all federal debt before the quantitative easing program began. In fiscal year 2009, the Fed then made net purchases of Treasury securities totaling $292 billion, followed by nearly $900 billion over the two-year period of 2010 and 2011 and $800 billion over the three-year period from 2012 through 2014. The Fed now owns $2.5 trillion in Treasury securities, or about 18 percent of all outstanding federal debt, which is well outside the historical norm.
The purpose of quantitative easing was to stimulate asset valuation by lowering long-term borrowing costs and thus also to encourage business expansion and consumption by households. It was also intended to make it easier for the federal government to run larger deficits and thus to provide fiscal stimulus to the national economy. This month, the average interest rate on a newly-issued 30-year mortgage is 3.43 percent, near the lowest level ever recorded. Fixed-rate 30-year mortgage rates have been below 5 percent continuously since January 2011.
Other central banks around the world have followed similar policies. The result has been a long-period of extremely low borrowing costs for governments. Amazingly, in 2016, the Congressional Budget Office (CBO) expects net interest payments on nearly $14 trillion in outstanding federal debt to total just $253 billion -- the same level of interest payments that were made by the federal government in 2008 on $5.8 trillion in debt.
Over the period of 2009 to 2016, the Fed went beyond Treasury securities and also made net purchases of $1.8 trillion in mortgage-backed securities (MBS) issued by Fannie Mae and Freddie Mac. Prior to 2009, the Fed had not ventured into the MBS market.
The Fed's policies have lowered deficits substantially during the Obama years in large part because of lower borrowing costs but also because of the earnings the Fed has booked on its unusual program of asset purchases. When the Treasury makes interest payments on outstanding federal debt, much of it goes to the Fed because of its large portfolio of Treasury-issued debt.
The returns the Fed earns on its Treasury and MBS assets are used to fund the bank's operating costs and to cover the expenses of the Consumer Financial Protection Bureau, created in Dodd-Frank. Beyond that, the excess "profits" can be returned, at the discretion of the Fed, to the federal Treasury to lower the government's annual budget deficit. In 2008, the Fed paid just $32 billion to the Treasury. Over the period 2009 through 2015, the central bank paid the Treasury a total of $584 billion, including $117 billion in 2015 alone.
Congress has noticed the Fed's large payments to the Treasury in recent years. The federal deficit was lower in these years because of the Fed's payments to the Treasury, and yet no taxes were raised, or spending cut. In 2015, Congress chose to take this practice one step further by requiring the Fed to make a special, one-time payment to the Treasury of an additional $19.3 billion. This required payment by the Fed was used to "pay for" expanded federal funding of highway construction and maintenance.
One does not need to be an aggressive Fed skeptic to see how dangerous the practice of the Fed returning "profits" to the Treasury could become. In recent years, the Fed has bought large amounts of Treasury securities (using funds effectively created through an expansion of the monetary base), thus reducing the need for the Treasury to secure funds from other sources. The Fed then earns returns on these Treasury holdings, which it returns to the Treasury to lower the apparent size of the government's budget deficit. It's certainly a novel way to pay for government activity.
At this point, there are economic and fiscal risks in every direction. If the economy remains sluggish, and demand suppressed, then interest rates are likely to remain low for some time, easing federal borrowing costs in coming years. But a slow growth economy is also disastrous for the federal budget, as revenue growth is below what it should be and enrollment in expensive benefit programs is higher than it needs to be. Moreover, if the economy were to slow precipitously, the Fed is in a very difficult position. The targeted federal funds rate is already extremely low (between 0.25 and 0.50 percent), and the central bank already owns far more in assets than ever before in its history. The next recession will be difficult to weather with monetary stimulus alone.
Meanwhile, if the U.S. were to return to a more normalized level of growth, employment, and inflationary pressure, much as that would be welcomed, it would likely trigger a resumption of more normalized net interest payments on the national debt. For instance, if the ratio of net interest payments to federal debt in 2018 were to be the same as it was in 2007, the total interest cost to the federal government of its outstanding debt would be $713 billion, or $350 billion more than is currently forecast in CBO's baseline estimates. Of course, federal revenue would also be higher than in the forecast because of stronger growth, but there's no guarantee the additional revenue would be high enough to cover the added debt service costs associated with more normal interest rates. The federal budget is already so badly out of balance that an additional, permanent increase in net interest payments could easily push the federal government closer to a fiscal crisis.
The United States is still grappling with the effects of the financial crash, recession, and slow recovery of recent years. The Fed chose a policy of unprecedented monetary accommodation, which has substantially eased the way for massive federal borrowing during the Obama presidency.
But the status quo seems unlikely to hold indefinitely. At some point one would expect both monetary and fiscal policy to move in the direction of more normalized positions. At that point, it will be clear that the budget outlook, bad as it has been, is actually even worse than people imagined.