The $31 Trillion Elephant in the Fed’s Room

So much of the Fed’s narrative surrounding inflation is focused on upward pressure on wages and the cost of professional services. This was, once again, reflected in last Friday’s release of the Personal Consumption Expenditures Index (PCE) — the Fed’s favorite inflation indicator.

What is never brought up at the post-Federal Open Market Committee press conferences is what I liken to the elephant in the room — namely the $31 trillion in federal debt that is growing at a rate that it will top $41 trillion by 2026 if some severe budget action by Congress isn’t taken into account.

As of November 2022, it costs $103 billion to maintain the debt, which is 11% of total federal spending. The national debt has increased every year over the past 10 years, and last Friday’s passage of the $1.7 trillion in yet another government funding bill to prevent a shutdown will also add to the national debt, as politicians can’t rein in out-of-control spending on several levels.

I think part of what the Fed is terrified of is seeing short-term interest rates staying elevated for an extended period. The U.S. central bank funds the interest on the debt by issuing one, two and three-year Treasury bills and notes. After seven interest rate hikes in 2022, the yields on these securities average around 4.5%. This presents a major dilemma for the Fed.

As short-term rates rise, it makes federal borrowing to service the elephant-sized debt way more expensive. This past May, the Congressional Budget Office (CBO) projected that annual net interest costs would total about $400 billion in 2022 and nearly triple over the next decade, soaring to $1.2 trillion annually and adding up to over $8 trillion over the next 10 years. And this forecast was done back in May, when inflation was much lower than where it stands today.

The growth in interest costs presents a major challenge over the long-term for the United States as well. According to the CBO’s model, interest payments could exceed $66 trillion over the next 30 years, absorbing nearly 40% of all federal revenues by 2052 — becoming the largest federal expenditure. It would exceed defense spending in 2029, Medicare in 2046 and Social Security in 2049.

One could argue that the Fed needs to wreck the economy to get inflation and interest rates back down to 2% in order to save the government from its own excesses. Key public investments into education, transportation, infrastructure, research and development (R&D) and other programs will be dramatically impacted if revenues aren’t increased and spending decreased.

With the assumption that Congress has no intention of reducing the rate of spending, the only way to seemingly balance the budget is to bring interest rates back down to deflationary levels and raise taxes on personal income, corporate sales and all manner of taxable items and services.

The current U.S. debt-to-gross-domestic-product ratio is 137%. In Japan, it is 262%. The latter economy hasn’t seen normalized growth since 1995. This multi-decade period of recessionary economic activity in Japan should be setting off alarm bells at the Fed and on Capitol Hill. It is the biggest challenge the Fed faces, and it is also why the U.S. central bank is beset with crushing the economy after blowing it by calling inflation “transitory.” By doing this, it unleashed the need for its now-hawkish policy.