Brian Motley

English

Research Papers in Economics

FABSF
November 23, 1984 WEEKLY LETTER
Interest Rates and the Federal Deficit
Earlier this year, the Congressional Budget Office
(CBO) and the OfficeofManagement and Budget
(OMB) released separate projectionsofthefederal
government's outlays and receipts between now
and1989. Althoughboth sets ofprojections imply
continued large deficits, they contain significant
differences. Whereas CBO estimated that the
overall budget deficit will increase year-by-year
to reach $278 billion by 1989,theOMBprojected
a modestdecline to $144 billion.
The huge difference ($134 billion) between these
alternative projections ofthe 1989 deficit results
from different forecasts of both the expenditures
and the receipts sides ofthe budget. However, one
item-outlays for interestpayments on the public
debt-accountsfor halfofthe differencebetween
the two. The CBO projects that expenditures on
interest payments will rise from $111 billion in
1984 to $214 billion in 1989, while OMB expects
these outlays to rise only to $147 billion.
The remainder ofthe difference between the two
deficit predictions results from differentestimates
both offuture tax receipts and ofnon-interest out-
lays. The OMB assumes a more ebullientecono-
my over the coming five years and hence projects
larger tax receipts and smaller outlays on transfer
payments than does the CBO. Indeed, in the Ad-
ministration's scenario, the budget exclusive of
interest outlays is projected to show a small ($3
billion) surplus in 1989, implying that all ofthe
deficit in that year will represent interest pay-
ments. Even in the CBO projections, the deficit
excluding interest payments is notexpected to
rise, so that all ofthe increase in the total projec-
ted deficitrepresents rising interestpayments. The
chart illustrates the two sets of projections.
Interest rates and deficit growth
The significantly lowerestimates offederal inter-
est payments in the OMB forecasts primarily re-
flect the Administration's more sanguine view of
future interest rate trends. The OMB estimates as-
sume, for example, that the interest rate on Trea-
sury billswill declinesteadilytoreach five percent
by 1989. Although theaverage interest rate on the
outstanding debt is expected to decline less rap-
idly-because muchofthedebtconsists oflonger
term securities-this assumption is more optimis-
ticthan thatused bythe CBO, which assumes that
the average interest cost ofthe debtwill remain
roughly constant at its present level-nine per-
cent-through the remainder ofthe decade.
Assumptions aboutfuture interest rates are critical
to deficit forecasting because the general level of
interest rates not only determines the cost of pay-
ing interest on the current debtbutalso influences
the pace at which the debtwill rise in the future
and hence how fast the interest cost ofthe debt
will rise. The last in turn influences the size ofthe
future deficits. For example, ifthe government
budget exclusive of interest payments were al-
ways exactly balanced-butall interest payments
were financed by borrowing-the government
debt and hence its outlays on debt interest would
growat a rate equal tothe interest rate. This would
mean, for example, that at an interest rate of nine
percent, the debt and the interest payments on it
would double within eight years, whereas it
would take fourteen years ifthe rate of interest
were only five percent. Obviously, the debt and
the interest on itwiII grow faster than the rate of
interest ifthe budget exclusive of interest pay-
ments is also in deficit. By the same token, thedebt
wilLgrow more slowly than the rate of interest to
the extent thatthe other partofthe budget is in
surplus.
IftheCBOand OMB deficitprojections are adjust-
ed to remove the difference in interest rate as-
sumptions, the gap between the two projectionsof
the 1989 deficit is reduced by about $50 billion.
Even after this adjustment, the CBO estimate of
1989 interest outlays is some $17 billion higher
than that ofthe OMB because the non-interest
portion ofthe deficit also is higher in the CBO
scenario and additional debt is required between
now and 1989 to finance this portion.
Internal consistency?
Since the CBO and OMB forecasts ofthe future
inflation rate arequite close, theirdifferentinterest
rate projections do not result from differences in
inflation premiums. Instead, the disagreement
over interest rates implies different views ofthe
future course of real, or inflation-adjusted, inter-FRBSF
est rates. Specifically, theAdministration's predic-
tions implythat the real short-term interest rate
wiII decline to about 1.5 percent by 1989-c1ose
to its long-run historical average. In contrast, the
CBO forecasts that this rate will remain close to
four percent-well above its historical norm-
throughoutthe second halfofthe decade.
The CBO scenario ofa four percent real interest
rate on governmentdebt could not be sustained
forlongunlessthere wereasubstantial surplus on
the non-interest portion ofthe budget. The reason
for this is the arithmetic of interest rates and gov-
ernment debtdescribedearlier. Again, the argu-
ment is most easily understood inthe case where
the non-interest partofthe government budget
remains in balance. In that case, the real value of
the debtwill rise at a rate equal to the real interest
rate, which in the CBO scenario is four percent.
Most economists believe that the long-run annual
real growth rate ofthe U.S. economy is approxi-
mately three percent. The CBO estimate ofa four
percent real interest rate therefore implies that the
real value ofthe public debtwill growfaster over
time than real GNP. This means that the ratio of
debt to GNPwill rise steadily.
A risingdebt/GNPratiowould putpressure on real
interest rates to rise to induce investors to absorb
more and more government securities into their
portfolios relative to their incomes. It is true, of
course, that investors would also be receiving ris-
ing incomes in the form ofgovernment interest
payments, but this would not meetthe govern-
ment's borrowing needs unless all ofthis in-
creased income were saved and lent back to the
government. A rising real interest rate in turn
means larger interest payments, which causes the
deficitto widen and debtto groweven faster. In
this way, a cycle is set up in which interest rates
and the deficitfeed on each other to produce an
explosivesituation. This tendencyfor interest rates
and the debtto chase each other ever upward
would be even greater if, as the CBO projects,
there also is adeficitonthe non-interestportionof
the budget.
The OMB scenario avoids this disturbing conclu-
sion by positing asteady decline in the real interest
rate toalevel well belowthe long-run real growth
rate ofthe economy. This scenario implies that
once the non-interest portion ofthe budget has
been brought into balance, the debt/GNP ratio
will steadily dedineeven ifall interest payments
are made outof new borrowing. Moreover, the
drop in the debt/GNP ratio reduces the pressure of
government borrowing in the financial markets to
finance interest payments, and this in turn helps
keep rates movingdownward. Thus, whereas the
CBO view implies an upward spiral in interest
rates and deficits, the OMB assumption implies a
downwardspiral. In fact, underthe OMB assump-
tion, itwould be possible to run a modest deficit
on the non-interest portion ofthe budget and still
have adebt/GNP ratio that does not rise.
Upordown?
Both scenarios appear to be internally consistent.
The CBO projection assumes continued high in-
terest rates which produce rising deficits which in
turn would tend to keep interest rates up. Con-
versely, the OMB forecast has declining interest
rates and deficits. Which, then, is more likelytobe
realized over the next five years? Unfortunately,
this is adifficultquestion to answerwithourexist-
ing knowledge.
In recent years, there has been considerable con-
troversy as to whether the observed high real in-
terestrates have resulted from the emergence of
the large and continuing federal deficit, the Fed-
eral Reserve System's relatively tight monetary
policy, or some other factor such as a rise in the
real productivity ofcapital in the United States.
Although most economists accept the view that
the emerging deficithas been one importantcause
(although not necessarily the sale cause) of high
rates, there is little quantitative evidence avail-
able on the relationship between the size ofthe
budget deficit (or the debt/GNP ratio) and the real
interest rate, simply because deficits have never
been this high relative to GNP during periods of
strong economic expansion.Hence, even ifwe accept the view that a rising
publicdebtputs upward pressure on interestrates,
we do not know the magnitude ofthis effect.
WhiIe the OMB and CBOscenarios are each logi-
callyconsistent, wedo notknowwhetherthey are
quantitatively so. That is, withoutquantitative in-
formation on how deficits affect interest rates, we
cannot confirm that the specific numbers projec-
ted fordeficits in each scenario are consistentwith
the assumed interest rates from which those pro-
jections were derived.
What is clear, however, is that in the long-run, a
situation involving atotal deficitthatequals or
exceeds the government's interest payments can-
not continue ifthe economy's real growth rate is
less than the real interest rate. Simple arithmetic
impliesthatifthegrowth rate oftheeconomyfalls
shortofthe interest rate, there mustbe asurplus on
the non-interest portion ofthe budget since other-
wise the government must borrow increasing
amounts merelyto meet its annual interest expen-
ditures. This surplus can onlybe achieved by either
reducing the growth of non-interest expenditures
or increasing tax receipts.
Brian Motley
Federal Deficit Versus
Interest on the Debt
$Billions
300
250
200
150
100
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1979 1980 1981 1982 1983 1984 1985 1986 19871988 1989
Opinionsexpressed in this newsletterdo not necessarily reflect theviews ofthe managementof the Federal Reserve Bank ofSan
Francisco,orofthe Board ofGovernorsofthe Federill Reserve System.
Editorialcommentsmaybeaddressedtotheeditor(GregoryTong) ortotheauthor....FreecopiesofFederal Reserve publications
can beobtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco
94120. Phone(415) 974-2246.BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollar amounts in millions)
·1!11?:> 'o:>SPUI?J:I UI?S
lSL ·ON IIWlHd
OIVd:J~VISOd·s·n
llVWssvn IS}!I:I
<HI}!OS:J}!d
Selected Assets and Liabilities
largeCommercial Banks
Amount
Outstanding
11/07/84
Change
from
10/31/84
uo~6u!4S0m 4o~n U060JO OpOA0U
040PI !!omoH O!UJoJ!l0) ouozPtl o~soltl
O)SI)UOJ~ UOS
JO ~U08
aAJaSa~ IOJapa~
~uaw~Jodaa l.pJOaSa~
Change from 12/28/83
Dollar Percentl
Loans, Leases and Investments1 2 186,599 880 10,574 6.9
Loans and Leases1 6 167,901 883 12,546 09.3
Commercial and Industrial 51,258 702 5,295 13.3
Real estate 61,274 ],11 2,375 4.6
Loans to Individuals 30,677 84 4,026 17.4
Leases 5,097 23 34 0.7
U.S. Treasury and Agency Securities2 11,595 21 - 912 - 8.4
Other Securities2 7,103 - 24 - 1,060 - 15.0
Total Deposits 192,009 357 1,012 0.6
Demand Deposits 45,190 - 340 - 4,047 - 9.4
Demand Deposits Adjusted3 30,126 826 - 1,205 - 4.4
Other Transaction Balances4 12,732 453 - 43 - 0.3
Total Non-Transaction Balances6 134,087 244 5,102 4.5
Money Market Deposit
Accounts·-Total 38,896 344 - 701 - 2.0
Time Deposits in Amounts of
$100,000 or more 40,984 - 187 2,819 8.5
Other Liabilities for Borrowed MoneyS 22,626 110 - 381 - 1.9
Two Week Averages.
of Daily Figures
Reserve Position, All Reporting Banks
Excess Reserves (+)/Deficiency(-)
Borrowings
Netfree reserves (+l/Netborrowed(-)
Period ended
11/05/84
55
133
78
Period ended
10/22/84
13
102
89
1 Includes loss reserves, unearned income, excludes interbank loans
2 Excludes trading account securities
3 Excludes U.S. government and depository institution deposits and cash items
4 ATS, NOW, Super NOWand savings accounts with telephone transfers
S Includes borrowingvia FRB, TI&L notes, Fed Funds, RPs and other sources
6 Includes items notshown separately
7 Annualized percent change

Interest rates and the federal deficit

http://www.frbsf.org/publications/economics/letter/1984/el84-47.pdf

Interest rates and the federal deficit

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Research Papers in Economics