Why the US deficit is a taxing issue for the Federal Reserve

The Federal Open Markets Committee continues to argue that it is ‘data dependent’ when it comes to setting monetary policy. The latest round of inflation figures is therefore likely to be very influential but two equally important numbers that get less attention than they should are US tax receipts and the Federal deficit – not least because the former is falling and the latter surging.

US tax receipts have fallen year-on-year for each of the past seven months, to suggest the American economy may not be firing on all cylinders, while the increased deficit means that higher interest rates will have an even greater impact on borrowers (including the government) and their ability to invest or spend.

Source: US Treasury

The figures for May from the US Treasury reveal that tax receipts fell $82 billion year-on-year to $308 billion. Meanwhile, spending continued unabated, rising $93 billion year-on-year, as the Biden administration continued to pour dollars into projects backed by the $369 billion Inflation Reduction Act and the $280 billion Chips and Science act, among others. Both were passed in 2022 and America is now investing that cash.

It is to be hoped that these projects bring positive returns and start to generate tax dollars through employment and exports, and even reduced imports thanks to onshoring and increased domestic production of vital technologies.

For now, however, the outlays are adding to the US deficit and that is an additional complication for a US Federal Reserve that is already having to balance growth, inflation and financial stability as it looks to find the appropriate level for interest rates.

This is because higher interest rates mean higher bond yields (as investors demand a higher return on fixed-income instruments to compensate themselves for the additional risk represented by bonds relative to cash) and higher bond yields increase the US Government’s interest bill.

This is now running at an annualised rate of nearly $928 billion a year, which is a big chunk of the $5 trillion received in tax in fiscal 2022, especially when welfare programmes take up another $3 billion or so. That does not leave room for a lot else (the interest bill now exceeds the defence budget) and the Fed will therefore be hoping that it does not have to push interest rates much higher.

Source: FRED -St. Louis Federal Reserve database

The increase to the debt ceiling out to January 2025 gives Capitol Hill a mandate to keep spending, but the growing interest bill means this comes at a cost.

Source: US Treasury, US Government Publishing Office. *2023 covers October to May only

America’s burgeoning debts may mean interest rates can only go so far before the strain on the national finances becomes too great and the Fed must either back off – or print money. Both, however, point to inflation.

We have been here before. President Nixon was juggling welfare payments and defence spending, because of the Vietnam war, and pulled the US off the gold standard, with an eye on combatting inflation too.

The results may have been initially encouraging but inflation (or at least stagflation) followed, as the cost of Nixon’s policies was borne in this way, helped along by the 1973 oil price shock.

Source: FRED – St. Louis Federal Reserve database

Perhaps this is the choice that faces America now. Austerity on one hand, something for which there is no political (or public) appetite, or inflation on the other, either thanks to lower interest rates, more QE or both.

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