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Ed Yardeni: Fiscal Policy: A Trillion Here, a Trillion There

The following excerpt is from Yardeni Research Morning Briefing (April 26, 2023).

We have been on Wall Street as economists and strategists for more than 40 years. Over that entire period, doomsters have been scribbling away, producing lots of articles and books about the US federal deficits and debt. The only pause in their doom and gloom was during the late 1990s and early 2000s, when the federal government ran a surplus for a brief time. Nevertheless, while the annual federal deficits are now measured in trillions rather than billions, doomsday has yet to occur (Fig. 3).

Of course, as a result of the pandemic, the US budget deficit ballooned to record levels as government outlays soared, while receipts were depressed (Fig. 4). On a 12-month basis, the deficit hit a record $4.1 trillion during March 2021. It briefly fell just below $1.0 trillion during July 2022. In March of this year, it was back at $1.8 trillion, as outlays have been outpacing receipts.

There's been one obvious adverse consequence of running such large deficits. The rebound in inflation since late 2021 undoubtedly was attributable to the three rounds of billions of dollars in pandemic relief checks sent by the government to millions of Americans in 2020 and 2021. All that fiscal stimulus combined with ultra-easy monetary policies amounted to "helicopter money," a concept discussed by economist Milton Friedman and former Fed Chair Ben Bernanke. That money drop triggered a buying binge, mostly for goods since many services providers were hampered by social-distancing restrictions. The resulting demand shock overwhelmed global supply chains and sent inflation soaring.

But so far, the consequences of massive deficits haven't been doomsday in nature. Nevertheless, it is hard to see how this doesn't end badly eventually. There is a doomsday mechanism built into the government's ever rising debt. The net interest paid by the government continues to grow rapidly, especially now that short-term interest rates have soared by 500bps over the past year. This outlay rose to a record $564.9 billion over the 12 months through March (Fig. 5). Just before the pandemic, it was $383.7 billion. However, the government's net interest outlays boost the income of investors who buy the government's securities at higher interest rates.

As Treasury issues mature and must be refinanced at higher interest rates, the government's outlays on net interest paid will continue to rise. We estimate that the average interest rate paid by the Treasury on its publicly held debt is currently around 2.20% (Fig. 6). At 3.00%, the annual net interest expense would be $740 billion currently.

So why isn't the deficit causing interest rates to soar? Consider the following:

(1) The Fed's holdings of Treasury, agency, and mortgage-backed securities peaked at a record high of $8.5 trillion during May 18, 2022. As a result of the Fed's quantitative tightening program, the Fed's holdings of these securities are down $633.8 billion to $7.9 trillion as of April 19 (Fig. 7).

The comparable securities held by commercial banks peaked at a record $4.7 trillion on February 23, 2022. They are down $570.7 billion since then through April 12.

(2) On the other hand, bank depositors have been moving their money into money market mutual funds (MMMF), which have been buying lots of Treasury bills. The assets of MMMF increased $739.7 billion y/y through April 19 (Fig. 8).

(3) The major buyers of US bonds over the past year have been foreigners. Over the past 12 months through January, they purchased a record $1.1 trillion in the US bond markets, led by $878.1 billion in Treasury notes and bonds (Fig. 9 and Fig. 10).

(4) We have long believed that actual and expected inflation and the Fed's reaction to inflation are more important in driving interest rates and the yield curve than supply and demand fundamentals. The latter two suggest that investors expect that inflation will moderate and the Fed will soon stop tightening.

(5) The main reason that mounting government deficits and debt haven't had major adverse consequences so far is that they represent a huge intergenerational transfer of wealth to the Baby Boomers from our children. We are leaving them a huge bequest of debt. On the other hand, they will also inherit lots of wealth from their parents, including plenty of government bonds.

Debbie Johnson & Ed Yardeni

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Posted: May 2, 2023 Tuesday 12:30 AM