Tuesday, December 19, 2023

Federal Reserve, Interest Rates, and the National Debt by Dr. Robin Dhakal

Understanding effects of the Federal Reserve's interest rate decisions is essential for everyone since it affects every aspect of our lives. Whether you're an individual saver, a business owner, or just trying to make sense of economic news, the Fed's actions are bound to impact your wallet. But what exactly is this influence and why does it matter? And how does this affect our national debt issue?

Let’s start with the basics.

The Federal Reserve is arguably the most important aspect of the US economic system because of its role in monetary policy. By setting the benchmark for short-term interest rates, the Fed indirectly guides borrowing costs across the country. These rates affect various aspects of the economy- everything from the interest on your savings account to the cost of taking out a loan for a new home or a business venture. When the Fed decides to hike up rates, as Bankrate explains, borrowing becomes more expensive. This doesn't just mean higher monthly payments on new loans; it also impacts interest rates on existing variable-rate debt like credit cards and home equity lines of credit. Conversely, when the Fed lowers rates, it encourages spending and investment which heats up the economy— but at the risk of stoking inflation.

The Fed's influence extends beyond personal finance. According to Federal Reserve publications, its monetary policy decisions directly sway interest rates and indirectly affect stock prices, wealth, and even currency exchange rates. It's a balancing act of monumental proportions, aiming to foster a stable economy that grows without overheating. But this is a delicate balance. As Investopedia reports, changes in interest rates can have long-lasting impacts. When rates rise, consumers and businesses may pull back on spending due to higher financing costs, potentially slowing the economy. On the flip side, when rates fall, spending can surge, driving up prices and possibly leading to inflation.

Industries are affected differently with interest rate changes. Real estate, for example, is sensitive to these fluctuations. Higher rates can cool down the housing market, as mortgages become expensive and potential buyers shy away. Conversely, banks might see this as an opportunity, with increased interest rates leading to wider profit margins on loans. Manufacturing firms with heavy reliance on borrowing may face challenges, as the cost of financing equipment or facilities rises. But not all is bad; sectors like consumer staples or utilities, which are less sensitive to economic cycles, may fare better in an environment of climbing rates.

So, how does this affect the Federal government?

At its core, the Fed's decision to adjust interest rates affects how much it costs the government to borrow money. Just like individuals, the federal government takes out loans to fund various initiatives, from infrastructure projects to social programs. These loans come in the form of Treasury bonds, bills, and notes that investors purchase. The interest rate set by the Fed, often referred to as the federal funds rate, indirectly influences the yield on these securities. A higher federal funds rate generally leads to higher Treasury yields, which translates into increased borrowing costs for the government.

History has shown us that declining interest rates can be a boon for the government. Lower rates mean cheaper borrowing costs, allowing for the financing of deficits at a more manageable expense. For years, we've seen a general downtrend in interest rates, even near-zero levels during economic crises such as the 2008 financial collapse and the COVID-19 pandemic. However, as the rates begin to rise, the scenario shifts. The recent trend, marked by the Federal Reserve's rate hikes, has seen an uptick in the cost of servicing the national debt. This means a larger portion of the government's budget must be allocated to paying interest, potentially constraining spending in other areas or leading to increased borrowing to cover these costs.

What about the national debt?

As interest rates climb, the cost of maintaining and adding to this debt grows. Each uptick in rates can mean billions of dollars in additional interest payments over time. This is no small matter when considering the scale of the U.S. national debt, which stands in the trillions of dollars. The interest payment on our national debt is close to $400 billion in 2023. This higher interest payments may lead to difficult budgetary choices, with potential cuts to services or the need for higher taxes to bridge the financial gap. It's a delicate balance.

In response to the economic downturn caused by the COVID-19 pandemic, the Fed implemented aggressive rate cuts to stimulate economic activity. The ultra-low interest rate environment resulted in increased government borrowing at historically low costs, allowing the federal government to finance its debt at favorable terms. However, as the economy began to recover and inflationary pressures increased, the Federal Reserve started gradually increasing interest rates. These post-COVID rate hikes were aimed at preserving price stability and preventing excessive inflation. As interest rates rose, the cost of borrowing for the federal government also increased, leading to a rise in future interest payments on the national debt.

What are the potential consequences of the future rate cuts?

The Fed's recent indication of potential interest rate cuts in 2024 raises questions regarding its impact on the national debt and the broader economy. While the exact effects are subject to numerous variables, we can explore potential implications based on economic principles and past experiences.

1)     If interest rates are cut, the federal government would benefit from lowered borrowing costs. This would alleviate the burden of interest payments on the national debt, freeing up resources for other priorities. However, it is crucial to note that this relief would be temporary, as future rate hikes, driven by inflationary pressures or economic growth, could again increase borrowing costs.

2)     A rate cut typically stimulates the economy by reducing borrowing costs for businesses and consumers. Lower interest rates incentivize borrowing and can boost investment, consumption, and overall economic activity. This stimulation could lead to increased tax revenues for the government, potentially improving its fiscal position and reducing the national debt over time.

3)     One potential consequence of rate cuts is an increase in inflation (again!) Despite the Fed's commitment to keeping inflation in check, a sustained period of low interest rates can potentially stimulate excessive borrowing and spending, fueling inflationary pressures. Inflation erodes the value of money, reducing the purchasing power of consumers and increasing the cost of living. This could indirectly impact the national debt by reducing the real value of outstanding debt obligations over time.

4)     U.S.'s fiscal and monetary policies has global implications. In a scenario where the Fed cuts interest rates while other central banks maintain or raise rates, it could lead to a depreciation of the U.S. dollar. A weaker dollar can increase demand for U.S. exports and make the national debt more manageable as it is denominated in U.S. dollars. However, this scenario can also raise concerns about international capital flows and the stability of the financial markets.

Tackling the national debt requires serious conversations around difficult issues. The solution involves cutting spending while increases taxes. Policymakers will have to make these tough decisions. While the solution to this problem ultimately rests with the Congress, the Fed is able to influence the debt with its monetary policy. However, it is important to note that while rate cuts could provide temporary relief on debt servicing costs and stimulate economic activity, they may also contribute to inflationary pressures and have broader implications for the global economy. It is important for policymakers to consider these economic principles and potential consequences when formulating monetary policy decisions.

Dr. Robin Dhakal Bio:

Dr. Robin Dhakal

Dr. Robin Dhakal is an Assistant Professor in the Forbes School of Business and Technology. He earned a M.A. and a Ph.D. in Economics from University of South Florida and a B.A. in Business/Economics and Mathematics/Computer Science from Warren Wilson College. His academic research focuses on development economics and political economy. He has been teaching Economics in colleges and universities for the past ten years. You can reach him at robin.dhakal@uagc.edu