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The Federal Reserve's new average inflation target will keep US payments on its record debt pile low even after policy interest rates rise from the zero lower bound, Kansas City Fed economist Huixin Bi told MNI.
The real cost of debt repayments will decline when interest rates are around zero while inflation and inflation expectations rebound, Bi said. "In the near-term, fiscal sustainability risk is very low," she said.
The U.S. government is paying less as it borrows at a record pace, and servicing the national debt will be cheaper than any time in the past half-century when measured against the size of the economy, Bi said in an interview before the Fed's blackout period late Friday.
With the economy screeching to a halt in the face of the coronavirus, the central bank took its benchmark interest rate to near-zero in March with markets expecting rates to stay there at least into 2024. The central bank has made clear that lifting rates off of zero is contingent on a "moderate" overshoot of inflation past 2% "for some time."
Though chances for more stimulus to aid the economy before the election are faint, there are currently several proposals floating around Congress. They range from a slimmed-down USD500 billion Senate Republican option to the USD1.9 trillion White House offer to the USD2.4 trillion advocated by the majority in the House of Representatives. Every USD200 billion in additional stimulus adds about 1% of GDP to the deficit.
The Fed's "new framework would not affect the fiscal limit and how much debt the U.S. government could take on before reaching a tipping point," she said. The new framework can provide additional space but it "does not shift the fiscal limit."
The U.S. government's debt, the nonpartisan Congressional Budget Office has said, will swell over the next 30 years to almost double the size of the economy. In its long-term budget outlook released in September, projected debt will reach 195% of gross domestic product in 2050, up from 79% in 2019.
If net federal debt reaches 150% of GDP, Bi said, sovereign default risk can rise to about 5%, and to 11% when debt to GDP is 200%.
"The government would have to either raise taxes or reduce government spending" down the road, she said. Most of the pressure would be on average tax rates and mandatory spending on such programs like Social Security, Medicare, and Medicaid, she said.
At 200% of GDP the risk of sovereign default could reach 40% when the government's "debt capacity is perceived to be lower" by investors, she wrote in a working paper with colleagues Wenyi Shen of Oklahoma State University and Shu-Chun Yang of the IMF.
"There is a fiscal limit at some point " and that limit will be determined not only by the economics but also by politics, she said.