Raising Interest Rates Could Have an Adverse Effect on Federal and State Budgets

Washington, DC – Last week, the BLS announced that unemployment had fallen to 5.5 percent. Many analysts and policymakers questioned whether this would spur the Federal Reserve raise interest rates as has long been speculated. A new report from the Center for Economic and Policy Research (CEPR) points out, though, that if the Fed were to raise e rates and keep unemployment from falling further, it would have a substantially negative impact on the budget.

The report, “The Budgetary Implications of Higher Federal Reserve Board Interest Rates,” calculates the plausible size of the impacts of a policy that uses higher interest rates to deliberately slow the economy. Dean Baker, Co-Director of CEPR and author of the report, demonstrates that a change of this nature in interest rate policy by the Fed would have serious consequences for both federal and state budgets.

The report details three separate channels through which changes in Federal Reserve Board policy would affect the federal budget picture.

The first is directly through higher interest rates. The report shows that if the ratio of interest to debt remained at its 2015 level, as opposed to the levels projected by the Congressional Budget Office (CBO), it would save the government almost $2.9 trillion in interest payments over the next decade. Even if the interest rate hikes were kept to just half the projected level the savings would be almost $1.5 trillion.

The second channel is through the interest on the assets purchased through the various quantitative easing programs. If all of these assets were held, rather than sold off rapidly, as assumed by CBO, the savings to the Treasury would be more than $600 billion over the course of the decade.

The third channel is through greater output and lower payments for unemployment benefits and other transfers, if the unemployment rate could fall back to its 2000 average of 4.0 percent and remain there. In this case the cumulative budgetary gains would be almost $1.9 trillion. As the paper notes, the key to the 1990s budget surpluses were not the spending cuts and tax increases put in place by President Clinton and Congress, but rather the willingness of the Greenspan Fed to allow the unemployment rate to fall to levels that were lower than most economists had believed were sustainable at the time.

The paper points out that sustaining a lower rate of unemployment would also have a large effect on state budgets. The higher output associated with lower unemployment would mean more tax revenue and less money paid out for unemployment benefits and other transfer payments. Assuming a 4.0 percent unemployment rate for 2016, the paper calculates that budgetary savings in California would be over $6 billion for the year. In Illinois, it would be almost $2 billion.

The Federal Reserve’s monetary policy should be based on its assessment of the state of the economy. Since there is a great deal of uncertainty about the economy’s potential and the degree of tightness in the labor market, this report argues that it is clearly appropriate for the Fed to weigh to relative costs and benefits of erring too tightly or loosely.

Baker writes, “Erring on the side of an overly tight monetary policy, which keeps millions of people from getting jobs and tens of millions from seeing wage growth also has the effect of making the budget picture more difficult at all levels of government.”

The full report can be found here.