HEARD ON THE STREET
Updated September 14, 2012, 2:53 p.m. ET
Fed Print Run Disguises Deficit
By DAVID REILLY
There is plenty of worry over the looming "fiscal cliff." Less talked about is the potential for a "Fed cliff."
The fiscal cliff refers to tax increases and reductions in government spending set to occur at the end of the year. If these take effect, they are expected to pose an economic hit possibly equal to as much as 4% of gross domestic product, likely throwing the U.S. into recession in 2013.
The Fed cliff is further off, but also daunting. It arises from the expansion of the Fed's balance sheet and the challenge that will come for the government when the central bank one day has to rein it in.
The Fed's balance sheet has risen to nearly $3 trillion from less than $1 trillion before the financial crisis and will grow further following Thursday's announcement that it will begin buying $40 billion a month in mortgage-backed securities.
The Fed's superlow interest-rate policies have already lowered government borrowing costs, even as the size of the overall debt has spiraled, and so have helped lower the annual deficit. And the central bank's stash of U.S. government debt—it held $1.64 trillion as of early September—along with its mortgage-securities portfolio have helped further reduce government interest expense. That is because of the extraordinarily circular process, where the Fed prints money to buy bonds, takes the interest it receives from the Treasury and mortgage securities, and returns most of it to the Treasury—$75 billion in 2011.
In fiscal 2011, net interest expense for the government was equal to 1.5% of gross domestic product, according to budget data. That is well below the average for the past 30 years. When the Fed remittances are taken into account, though, the expense fell to about 1% of GDP. This also helps to reduce the size of the government's annual operating deficit, which the administration said was $1.164 trillion for the first 11 months of fiscal 2012.
The government should continue to enjoy this Fed-induced benefit in the coming year. Even if rates on the 10-year Treasury note increase somewhat from current levels, so too should Fed remittances as its balance sheet expands further.
For the moment, it is tough to see this situation changing anytime soon. Indeed, the Fed left the timing of its monthly purchase open ended, and it also extended to mid-2015 the period for which it expects to keep interest rates at near-zero levels.
Eventually, though, assuming the economy one day recovers, rates will have to rise. In a February speech, New York Fed President William Dudley noted that once the economy improves, the Fed will pursue a different monetary policy, leading to higher short-term rates and a shrinking of its balance sheet. "These actions will tend to increase the Treasury's net interest costs and pull down the Federal Reserve's remittances to the Treasury," he said. "Together, these two effects will sharply push up the Treasury's net interest burden."
To illustrate his point, Mr. Dudley outlined an economic scenario in which monetary policy is normalized by 2017 and the interest rate for three-month Treasury bills rises to about 3.8% in 2020, compared with 0.10 percentage point currently. With the government's interest expense rising, and the Fed's remittances shrinking, net interest expense would rise to about 3.3% of GDP in 2020, the highest level since 1948.
All the more reason for the government to quickly tackle the country's long-term fiscal issues, not just the immediate "fiscal cliff." The danger is that politicians dither, figuring the Fed is there to support both the economy and their profligate ways.
In that case, the government may find it is the recovery that really hurts.
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