More Than Meets the Eye: Some Fiscal Implications of Monetary Policy
Marco Del Negro, James J. McAndrews, and Julie Remache
In 2012, the Fed’s remittances to the U.S. Treasury amounted to $88.4 billion. The vast majority of these remittances originated as income from the SOMA portfolio (see the second post in this series for an account of the history of SOMA income). While net income has been high in recent years because of the Fed’s large balance sheet, it is likely to drop in the future as the Fed normalizes interest rates. This is because the Fed will likely face increased interest expense on its reserve balances and possibly realize losses in the case of asset sales. A recent paper by economists at the Board of Governors of the Federal Reserve System (Carpenter et al.) shows that under some scenarios the Fed may be forced to decrease its remittances to zero for a few years (see also the related work by Hall and Reis and by Greenlaw, Hamilton, Hooper, and Mishkin). The fact that remittances may vary more over the next few years than they have in the past has highlighted the fact that monetary policy has fiscal implications.
This post tries to cast the fiscal implications of monetary policy for public finances in a broad context. Like every household or firm, the federal government has a budget constraint: if it spends more than its revenues, it needs to accumulate debt (see the federal government’s flow of funds, Table F.105 of the Financial Accounts of the United States, Federal Reserve Z.1 statistical release). Broadly speaking, government expenditures consist of purchases of goods and services, transfers (for example, to state and local governments), and the cost of servicing any interest-bearing debt. Government revenues come from taxes, tariffs, and remittances from the central bank. The Fed too has a budget constraint (see the Federal Reserve H.4.1 statistical release): it derives income from its assets, has to pay operating expenses and interest on reserves, and, after adding to its capital stock and paying dividends, remits what is left to the Treasury (see Carpenter et al. for a more detailed description). Note that, unlike the federal government, the Fed does not pay interest on all of its liabilities: currency—a unique liability of the Fed—pays no interest.
Since the central bank’s remittances to the Treasury enter the federal government budget constraint, it is useful to analyze the consolidated government budget (at the federal level) by summing together the Fed's and the federal government's budget constraints. To do this, you add the Fed's assets (SOMA portfolio, including Treasury debt held by the Fed) and liabilities (currency and reserves) to the federal government’s assets and liabilities (Treasury debt outstanding), and net out those Treasury liabilities that are owned by the central bank. As soon as you've done that you realize that
- by issuing currency—a liability that pays no interest—the Fed has reduced the interest expense of the government.
This portion of Fed income is called seigniorage, the income derived from issuing paper currency. It also follows that
- by issuing interest-bearing reserves and using them to buy longer-term government debt (as in most of the Fed’s large-scale asset purchase [LSAP] operations), the Fed changes the maturity composition of the consolidated government debt. (In contrast, when the Fed buys agency mortgage-backed securities or debt issued by either Fannie Mae or Freddie Mac, it expands the consolidated government balance sheet since such debt is not a liability of the federal government.)
Why has the maturity composition of the consolidated government debt changed because of the Fed’s actions? From the consolidated government view, reserves are simply very short-term government liabilities. So from the perspective of public finances, an LSAP swaps long-term for short-term government debt. Is this a good idea in terms of public finances? An LSAP that swaps long-term for short-term debt leaves the government, and therefore ultimately the taxpayer, exposed to a different interest rate risk profile, so that when rates go down, it may lower government financing costs—as measured by coupon and interest payments on debt—and vice versa when rates go up. The changes in consolidated government financing costs resulting from LSAPs partly show up in the federal government budget constraint as changes in remittances from the Fed. Therefore, in recent years, as LSAPs have been large and interest rates low, remittances have been high, but if rates were to increase, remittances would decrease, as pointed out by Carpenter et al., Hall and Reis, and the New York Fed’s report Domestic Open Market Operations during 2012.
It is important to bear in mind, however, that the implications of Fed policy for government finances are much broader than the direct influence that remittances from the Fed’s earnings have on government finances. In fact, monetary policy influences the government’s finances in three additional ways:
- Monetary policy affects economic activity, with implications for both revenues (for example, via tax collection) and expenditures (for example, because of automatic stabilizers).
- Monetary policy affects Treasury borrowing costs. This is true not only when the Fed changes interest rates with “conventional” monetary policy, but also when it changes rates with “unconventional” monetary policy (for example, LSAPs) via an effect on risk premia (see Gagnon, Raskin, Remache, and Sack).
- Monetary policy affects inflation. U.S. government debt is mostly nominal, which implies that changes in inflation affect the real cost of financing the debt.
The combined effects of these last three channels are likely quite large. As we’ll explain below, through an illustrative scenario, the direct effects of monetary policy on economic activity can have an extremely large impact on government revenues and expenditures. To gauge the effects of monetary policy on borrowing costs directly and through inflation, we can gain some insight from a calculation by Christopher Sims in his AEA presidential address. Sims provides a rough calculation of the historical impact of surprise changes in interest rates and inflation on the real value of U.S. debt as a percentage of GDP, thereby giving us some sense of the magnitude of the effects from the last two channels. He finds that since the 1960s these effects have been large—“about the same magnitude of fluctuations as year-to-year fluctuations in the fiscal deficit”—again suggesting that these indirect effects of monetary policy on the government’s finances are substantial.
Understandably, the attention given to the fiscal implications of LSAPs has focused on what’s most visible—namely remittances—because they appear as a line item in the federal budget. But the broader implications are also important, even if more difficult to measure. In principle, it is possible that returns to asset purchases, if measured narrowly by net income, could be negative, but the overall fiscal effect is still positive.
Imagine a hypothetical scenario where, without LSAPs, the U.S. economy would have spun into a deflationary spiral. In that case, the real value of nominal government debt would have gone up, while revenues would have slumped in real terms. Remittances, measured in real terms, would likely have been quite high. Nonetheless, even from a pure public-finance perspective—leaving aside, for instance, any consideration of the (large) cost of unemployment—avoiding such a scenario would save the government a great deal in financing costs, and is therefore a good result from that narrow perspective.
The LSAPs were part of the policies carried out by the Fed that may have helped steer the economy away from a deflationary spiral. As such, these policies were a good idea from a taxpayer’s point of view, even if they implied that remittances might be zero for a few years. In any case, our hypothetical scenario illustrates the need, when assessing the effects of monetary policy on the consolidated government balance sheet, to consider all the ways that monetary policy influences the economy, and thereby the government’s taxes and expenditures, and not just the more easily observable remittances made by the Fed each year to the U.S. Treasury.
The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.
Marco Del Negro is an assistant vice president in the Federal Reserve Bank of New York’s Research and Statistics Group.
James J. McAndrews is an executive vice president and director of research at the Bank.
Julie Remache is a vice president in the Bank’s Markets Group.