The Federal Reserve Bank’s monetary policies of increasing interest rates and “quantitative tightening”—reducing its $8.9 trillion balance sheet—will increase the volume and cost of government borrowing at all levels. It will slam the federal budget and state budgets as well, especially states in chronically weak fiscal condition such as Connecticut, despite its recent improvement.
The impact will be felt even without a recession, but if the economy does contract, the federal government will have limited capacity to employ fiscal stimulus to spur a recovery or to provide aid to struggling states.
Since February 2020, publicly held U.S. Treasury debt has exploded from about $17 trillion to $24 trillion. Almost half of the increase has wound up at the Fed, whose Treasury holdings have ballooned from $2.5 trillion to $5.8 trillion.
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Quantitative tightening is a big initiative. In May, the Fed announced plans to reduce its Treasury holdings by $330 billion by year end, and by $720 billion annually thereafter until its balance sheet shrinks to a yet-to-be-determined size. The Fed can reduce its balance sheet, but that doesn’t mean the federal government can reduce its balance of outstanding debt, nor that states can do so.
Given the extraordinarily low interest rates on new federal and state debt issued during the recent economic shutdown, federal and state interest costs barely increased despite the $7 trillion increase in Treasury debt and the $2 billion increase in Connecticut, for example.
Over the last three federal fiscal years ending on Sept. 30, 2021, total federal gross interest cost was $573 billion, $523 billion and $562 billion. (Net interest, after interest income mostly in government trust accounts, is $150 to $250 billion lower.)
Interest in Connecticut has been flat for five years at about $1.1 to $1.2 billion.
That is changing. The Fed has increased short-term rates by 2.25% following its 0.75% rate increases today and in June and smaller increases in March and May. According to the Fed’s own official guidance, it will increase rates further by at least 3% by the end of 2022.
As this additional 3% works its way into the refinancing of maturing Treasurys and Connecticut State bonds, federal and state interest costs will soar.
There are about $3.7 trillion outstanding Treasury bills, which mature in less than a year. Within a year, the 3% rate increase will generate roughly $105 billion in additional annual interest expense just on these short-term Treasurys.
Already, total federal gross interest cost over the last 12 months through June 30th has increased to $664 billion ($427 billion, net). If we add the impending extra interest only on Treasury bills (ignoring longer-term Treasuries), that figure rises to $769 billion, a staggering cost. National defense spending was $745 billion over this period; Medicare spending was $700 billion.
In fiscal year 2021, Connecticut borrowed about $2.8 billion; in fiscal 2022, about $2.7 billion, roughly equal to 10% of total state debt outstanding. In December 2021, the state borrowed at an interest cost of 1.98%; in May 2022, at 3.92%, or an interest rate almost twice as high. The extra 2% will cost the state $56million within one year.
If rates stay high, interest will increase another $56 million each year thereafter, reaching $112 million in the second year, $168 million in the third and so on.
The federal government can borrow to pay interest. Since it is in perpetual deficit, it is inevitable that it will do so.
By law, Connecticut cannot borrow to cover operating expenses such as interest. In the short term it can draw funds from the Budget Reserve Fund, or “Rainy Day Fund.” Yet, what happens if high rates persist or go higher? What happens if, as widely expected, recession hits on top of higher rates and the state’s various revenue streams reduce, forcing a rapid drawdown and a depletion of the BRF? The only options are spending cuts or increased taxes, or both.
The sharp selloff in equity markets is sure to severely depress capital-gains tax revenue, which averages more than 10% of federal individual income-tax revenue and an even higher percentage in Connecticut. Such revenue is now reversing from a historic peak in 2021.
Under current Fed policy, the federal government’s annual gross interest expense could reach $1 trillion. As rates rise an Uncle Sam borrows even more to pay the extra interest expense, a vicious cycle ensues as more interest expense necessitates ever more borrowing.
This dire outlook has been long coming. The U.S. and states such as Connecticut have been on unsustainable fiscal and financial paths for a long time. We are beginning to see the inevitable result at the federal level. At the state level, the worrisome outlook is camouflaged by the influx of massive federal Covid assistance money. But, when that has been spent, things will look different.
This is an updated version of a column which appeared previously in The Wall Street Journal.
Mr. Jahncke is president of The Townsend Group Intl, LLC, based in Connecticut.