The combination of quantitative easing and rising federal debt give rise to inflation worries.
In his classic novel “The Time It Never Rained,” Elmer Kelton wove a number of subplots into the story of a West Texas rancher battling the drought of the ’50s. One of those was the rancher’s relationship with the person he leased part of his operation from.
The landlord was an alcoholic and the lease payments on the ranch kept him in booze. As the drought progressed, Charlie Flagg, the main character, begged the landlord to cut the lease rate so he could run fewer sheep. The landlord refused. When the drought got so bad that Charlie turned the land back, the alcoholic landlord suddenly found himself short of easy drinking money.
Could the federal government one day find itself cut off from its easy drinking money? Perhaps, says Ernie Goss, Jack A. MacAllister chair in regional economics at Creighton University in Omaha, NE.
“Since 2008, the U.S. federal government has run yearly deficits in excess of $1 trillion and has expanded its debt to $16.4 trillion,” Goss says. “Despite this borrowing binge, interest rates on U.S. debt hover at record lows. Why? To paraphrase former Wyoming Sen. Alan Simpson, U.S. debt is the healthiest horse in the glue factory.”
By that, Goss means that investors are lending to the U.S. Treasury because all other options are more risky. But it goes beyond that, he says.
“During its 100 years of operations, the Federal Reserve never matched its current aggressive monetary expansion activities. Since December 2008, the Fed has held its short-term interest rate close to 0%,” Goss says.
What’s more, the Fed has launched three bond buying programs, termed quantitative easing 1, 2 and 3 (QE1, QE2 and QE3). When the fed launched QE 1 in November 2008, the yield, or market interest rate, on 10-year U.S. Treasury bonds was 3.3%, Goss says.
QE3 was inaugurated in September 2012, with the Fed currently purchasing $85 billion/month of long-dated Treasury bonds and mortgage-backed securities. The result is a driving down of the rate on U.S. Treasury bonds to an even lower 1.8%, he points out.
“At present, the Fed holds more than $3 trillion in bonds, or about 18% of total U.S. federal debt,” Goss says. “By buying U.S. Treasury bonds and keeping interest rates artificially low, the Fed has incentivized the U.S. government to borrow and overspend.”
When the Fed begins to sell these bonds, which they will, interest rates will move in the opposite direction, Goss says. “A return to pre-QE1 interest rates would cost U.S. taxpayers as much as $240 billion/year. Who will bear this guaranteed added burden?” Goss asks.
The answer to that question could be very economically painful.