I often hear that the Federal Reserve can’t hike interest rates too much (perhaps not enough to control inflation) because then the federal government would be unable to service its debts. Is this actually true?
The Fisher relation says such a hike has to either raise real interest rates or raise expected inflation. If you believe the interest rate hikes would go more into real interest rates than inflation then worrying about this is justified in principle, but in general there’s no good explanation of why the central bank raising nominal interest rates would raise real interest rates for a long time, say more than the few years it might take for prices and wages to adjust.
If the hike goes into expected inflation instead, then it’s true that the US government has to pay more nominal interest to roll over short-term debts, but they also collect more taxes because of inflation as the tax base becomes larger in nominal terms. Inflation is actually a fiscal benefit to the government in this case, as it ends up devaluing the long-term debt that the government owes.
The US government is sufficiently creditworthy that a few years of higher real interest rates would most likely not leave it in any danger of being unable to service its debts, but I admit there is some small risk every time real interest rates go up that markets end up losing confidence in the US government and refuse to roll over the trillions of dollars of Treasury bills that would need to be rolled over to prevent a debt default, either explicitly or implicitly through an inflating away of nominal debts.
Link to explanation of how/why this would work?
Market monetarists are one group that has been vocal in recommending this kind of policy, specifically with NGDP futures. From the wiki page:
Market monetarists advocate that the central bank clearly express an NGDP target (such as 5–6 percent annual NGDP growth in ordinary times) and for the central bank to use its policy tools to adjust NGDP until NGDP futures markets predict that the target will be achieved.
Alternatively, the central bank could let markets do the work. The bank would offer to buy and sell NGDP futures contracts at a price that would change at the same rate as the NGDP target. Investors would initiate trades as long as they saw profit opportunities from NGDP growth above (or below) the target. The money supply and interest rates would adjust to the point where markets expected NGDP to reach the target. These “open market operation”s (OMOs) would automatically tighten or loosen the money supply and raise or lower interest rates. The bank’s role is purely passive, buying or selling the contracts. This would partially or completely replace other bank’s use of interest rates, quantitative easing, etc., to intervene in the economy.
The Fisher relation says such a hike has to either raise real interest rates or raise expected inflation. If you believe the interest rate hikes would go more into real interest rates than inflation then worrying about this is justified in principle, but in general there’s no good explanation of why the central bank raising nominal interest rates would raise real interest rates for a long time, say more than the few years it might take for prices and wages to adjust.
If the hike goes into expected inflation instead, then it’s true that the US government has to pay more nominal interest to roll over short-term debts, but they also collect more taxes because of inflation as the tax base becomes larger in nominal terms. Inflation is actually a fiscal benefit to the government in this case, as it ends up devaluing the long-term debt that the government owes.
The US government is sufficiently creditworthy that a few years of higher real interest rates would most likely not leave it in any danger of being unable to service its debts, but I admit there is some small risk every time real interest rates go up that markets end up losing confidence in the US government and refuse to roll over the trillions of dollars of Treasury bills that would need to be rolled over to prevent a debt default, either explicitly or implicitly through an inflating away of nominal debts.
Market monetarists are one group that has been vocal in recommending this kind of policy, specifically with NGDP futures. From the wiki page: