Large Budget Deficits Won’t Push Up Interest Rates

Posted February 11, 2024

A few days ago, the Congressional Budget Office released its estimates for the size of the US Government’s annual budget deficits for the next 10 years.  The CBO expects budget deficits of $1.5 trillion this year, $1.8 trillion next year, and $1.7 trillion the year after that.

Many people worry that government borrowing to fund such large budget deficits will drive up interest rates.  This week’s Macro Watch video explains why they won’t.

Government borrowing does not drain Liquidity from the financial markets so long as the government spends the money that it borrows.  Government borrowing drains Liquidity, but Government spending reinjects that Liquidity back into the financial markets.

The video shows that there is no danger that a shortage of Liquidity will drive up interest rates in the near term.  In fact, after so many rounds of Quantitative Easing between 2008 and 2022, the Fed must pay interest on Bank Reserves and on Reverse Repurchase Agreements to prevent interest rates from plunging. That’s how the Fed controls the Federal Funds Rate.

The video explains how the level of Liquidity in the financial markets is affected by changes in the amount of funds held in Bank Reserves, Reverse Repos and the Treasury General Account (TGA).

It also discusses how Liquidity is created and destroyed through Quantitative Easing and Quantitative Tightening.  

And it points out that it is Quantitative Tightening, not government borrowing, that is draining Liquidity out of the financial markets – at the rate of $95 billion a month.  Therefore, it is QT, not budget deficits, that investors need to worry about.

Next, the video provides an update on Inflation.  It shows that all three component parts of the Core Personal Consumption Price Index are slowing rapidly (with Core Goods Prices actually deflating).  These trends suggest Inflation will soon fall back to the Fed’s 2% target and support the idea that interest rate cuts and a reduction in the pace of Quantitative Tightening are on the horizon.

This outlook for Inflation and Monetary Policy creates a positive environment for stocks and many other asset classes during the months ahead. But, of course, there are risks.  Macro Watch subscribers can log in and view this video now to find out what those risks are and for all the details on the topics outlined above.

The video is 27 minutes long and contains 54 slides that can be downloaded.  

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