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FABSF WEEKLY LETTER
November 23, 1984

Interest Rates and the Federal Deficit
Earlier this year, the Congressional Budget Office
(CBO) and the Office of Management and Budget
(OMB) released separate projections of the federal
government's outlays and receipts between now
and1989. Althoughboth sets of projections imply
continued large deficits, they contain significant
differences. Whereas CBO estimated that the
overall budget deficit will increase year-by-year
to reach $278 billion by 1989,theOMB projected
a modest decline to $144 billion.
The huge difference ($134 billion) between these
alternative projections ofthe 1989 deficit results
from different forecasts of both the expenditures
and the recei pts sides of the budget. However, one
item -outlays for interestpayments on the public
debt -accounts for half of the difference between
the two. The CBO projects that expenditures on
interest payments will rise from $111 billion in
1984 to $214 billion in 1989, while OMB expects
these outlays to rise only to $147 billion.
The remainder of the difference between the two
deficit predictions results from different estimates
both of future tax receipts and of non-interest outlays. The OMB assumes a more ebullient economy over the coming five years and hence projects
larger tax receipts and smaller outlays on transfer
payments than does the CBO. Indeed, in the Administration's scenario, the budget exclusive of
interest outlays is projected to show a small ($3
billion) surplus in 1989, implying that all of the
deficit in that year will represent interest payments. Even in the CBO projections, the deficit
excluding interest payments is not expected to
rise, so that all of the increase in the total projected deficit represents rising interest payments. The
chart illustrates the two sets of projections.
I nterest rates and deficit growth
The significantly lower estimates of federal interest payments in the OMB forecasts primarily reflect the Administration's more sanguine view of
future interest rate trends. The OMB estimates assume, for example, that the interest rate on Treasury bills will decline steadily to reach five percent
by 1989. Although the average interest rate on the
outstanding debt is expected to decline less rapidly -because much of the debt consists of longer

term securities -this assumption is more optimistic than that used by the CBO, which assumes that
the average interest cost of the debt will remain
roughly constant at its present level-nine percent -through the remainder of the decade.
Assumptions about future interest rates are critical
to deficit forecasting because the general level of
interest rates not only determines the cost of paying interest on the current debt but also influences
the pace at which the debt will rise in the future
and hence how fast the interest cost of the debt
will rise. The last in turn influences the size of the
future deficits. For example, if the government
budget exclusive of interest payments were always exactly balanced -but all interest payments
were financed by borrowing-the government
debt and hence its outlays on debt interest would
grow at a rate equal to the interest rate. This would
mean, for example, that at an interest rate of nine
percent, the debt and the interest payments on it
would double within eight years, whereas it
would take fourteen years if the rate of interest
were only five percent. Obviously, the debt and
the interest on it wi II grow faster than the rate of
interest ifthe budget exclusive of interest payments is also in deficit. By the same token, the debt
wilLgrow more slowly than the rate of interest to
the extent that the other part of the budget is in
surplus.
IftheCBO and OMB deficit projections are adjusted to remove the difference in interest rate assumptions, the gap between the two projections of
the 1989 deficit is reduced by about $50 billion.
Even after this adjustment, the CBO estimate of
1989 interest outlays is some $17 billion higher
than that of the OMB because the non-interest
portion of the deficit also is higher in the CBO
scenario and additional debt is required between
now and 1989 to finance this portion.
Internal consistency?
Si nce the CBO and OMB forecasts of the future
inflation rate are qu ite close, their different interest
rate projections do not result from differences in
inflation premiums. Instead, the disagreement
over interest rates implies different views of the
future course of real, or inflation-adjusted, inter-

FRBSF
est rates. Specifically, the Administration's predictions imply that the real short-term interest rate
wi II decl ine to about 1.5 percent by 1989-c1ose
to its long-run historical average. In contrast, the
CBO forecasts that this rate will remain close to
four percent -well above its historical normthroughout the second half of the decade.
The CBO scenario of a four percent real interest
rate on government debt could not be sustained
for long unless there were a substantial surplus on
the non-interest portion of the budget. The reason
for this is the arithmetic of interest rates and government debt described earlier. Again, the argument is most easily understood inthe case where
the non-i nterest part of the government budget
remains in balance. In that case, the real value of
the debt will rise at a rate equal to the real interest
rate, which in the CBO scenario is four percent.
Most economists believe that the long-run annual
real growth rate of the U.S. economy is approximately three percent. The CBO estimate of a four
percent real interest rate therefore implies that the
real value of the public debt will grow faster over
time than real GNP. This means that the ratio of
debt to GNP will rise steadily.
A rising debt/GNP ratio would put pressure on real
interest rates to rise to induce investors to absorb
more and more government securities into their
portfolios relative to their incomes. It is true, of
course, that investors would also be receiving rising incomes in the form of government interest
payments, but this would not meet the government's borrowing needs unless all of this increased income were saved and lent back to the
government. A rising real interest rate in turn
means larger interest payments, which causes the
deficit to widen and debt to grow even faster. In
this way, a cycle is set up in which interest rates
and the deficit feed on each other to produce an
explosive situation. This tendency for interest rates
and the debt to chase each other ever upward
would be even greater if, as the CBO projects,
there also is a deficit on the non-interest portion of
the budget.

The OMB scenario avoids this disturbing conclusion by positing a steady decline in the real interest
rate to a level well below the long-run real growth
rate of the economy. This scenario implies that
once the non-i nterest portion of the budget has
been brought into balance, the debt/GNP ratio
will steadily dedine even if all interest payments
are made out of new borrowing. Moreover, the
drop in the debt/GNP ratio reduces the pressure of
government borrowing in the financial markets to
finance interest payments, and this in turn helps
keep rates moving downward. Thus, whereas the
CBO view implies an upward spiral in interest
rates and deficits, the OMB assumption implies a
downward spiral. In fact, under the OMB assumption, it would be possible to run a modest deficit
on the non-interest portion of the budget and still
have a debt/GNP ratio that does not rise.
Up or down?
Both scenarios appear to be internally consistent.
The CBO projection assumes continued high interest rates which produce rising deficits which in
turn would tend to keep interest rates up. Conversely, the OMB forecast has declining interest
rates and deficits. Which, then, is more likely to be
realized over the next five years? Unfortunately,
this is a difficult question to answerwithour existing knowledge.
In recent years, there has been considerable controversy as to whether the observed high real interestrates have resulted from the emergence of
the large and continuing federal deficit, the Federal Reserve System's relatively tight monetary
policy, or some other factor such as a rise in the
real productivity of capital in the United States.
Although most economists accept the view that
the emerging deficit has been one important cause
(although not necessarily the sale cause) of high
rates, there is little quantitative evidence available on the relationship between the size of the
budget deficit (or the debt/GNP ratio) and the real
interest rate, simply because deficits have never
been this high relative to GNP during periods of
strong economic expansion.

Hence, even if we accept the view that a rising
publ ic debt puts upward pressure on interest rates,
we do not know the magnitude of this effect.
Wh iIe the OMB and CBO scenarios are each logically consistent, we do not know whether they are
quantitatively so. That is, without quantitative information on how deficits affect interest rates, we
cannot confirm that the specific numbers projected for deficits in each scenario are consistent with
the assumed interest rates from which those projections were derived.

exceeds the government's interest payments cannot continue if the economy's real growth rate is
less than the real interest rate. Simple arithmetic
implies that if the growth rate of the economy falls
short of the interest rate, there must be a surplus on
the non-interest portion of the budget since otherwise the government must borrow increasing
amounts merely to meet its annual interest expenditures. This surplus can only be achieved by either
reducing the growth of non-interest expenditures
or increasing tax receipts.

Brian Motley

What is clear, however, is that in the long-run, a
situation involving a total deficit that equals or

Federal Deficit Versus
Interest on the Debt
$Billions

300

CBO

250
200

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CBO
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OMB

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150
100

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50

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1979 1980 1981 1982 1983 1984 1985 1986 19871988 1989

Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of San
Francisco, or of the Board of Governors of the Federill Reserve System.
Editorial comments may be addressed to the editor (Gregory Tong) or to the author .... Free copies of Federal Reserve publications
can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco
94120. Phone (415) 974-2246.

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BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT

Two Week Averages.
of Daily Figures
Reserve Position, All Reporting Banks
Excess Reserves (+ )/Deficiency (-)
Borrowings
Net free reserves (+ l/Net borrowed( -)

Amount
Outstanding
11/07/84
186,599
167,901
51,258
61,274
30,677
5,097
11,595
7,103
192,009
45,190
30,126
12,732
134,087

Change
from
10/31/84

-

Period ended
11/05/84
55
133
78

880
883
702
],11
84
23
21
24
357
340
826
453
244

-

-

-

10,574
12,546
5,295
2,375
4,026
34
912
1,060
1,012
4,047
1,205
43
5,102

-

-

-

2.0

187
110

-

2,819
381

-

8.5
1.9

Period ended
10/22/84
13
102
89

Excludes trading account securities

Annualized percent change

-

701

S Includes borrowing via FRB, TI&L notes, Fed Funds, RPs and other sources
7

-

-

3 Excludes U.S. government and depository institution deposits and cash items
4 ATS, NOW, Super NOW and savings accounts with telephone transfers
6 Includes items not shown separately

-

-

6.9
09.3
13.3
4.6
17.4
0.7
8.4
15.0
0.6
9.4
4.4
0.3
4.5

344

38,896
40,984
22,626

Change from 12/28/83
Dollar
Percentl

1 Includes loss reserves, unearned income, excludes interbank loans
2

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(Dollar amounts in millions)

Loans, Leases and Investments 1 2
Loans and Leases 1 6
Commercial and Industrial
Real estate
Loans to Individuals
Leases
U.S. Treasury and Agency Securities 2
Other Securities 2
Total Deposits
Demand Deposits
Demand Deposits Adjusted 3
Other Transaction Balances4
Total Non-Transaction Balances6
Money Market Deposit
Accounts·-Total
Time Deposits in Amounts of
$100,000 or more
Other Liabilities for Borrowed MoneyS

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Selected Assets and Liabilities
large Commercial Banks

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