Latest / The Macro Memo with Fexingo: Daily Conversations on Inflation, GDP, and Federal Reserve Policy / The $40 Trillion Debt and Why the Fed Ignores It
Transcript
- Lucas: So, the national debt just crossed forty trillion dollars for the first time, and it doubled in about a decade. That's a number that feels too big to wrap your head around, but it's real. And the thing is, the Fed is basically ignoring it. Luna: Ignoring it? That seems like a huge deal. How can they just ignore forty trillion? Lucas: Well, because it's not their job. The Fed's dual mandate is maximum employment and price stability. They don't have a mandate for the debt. But there's a more interesting angle here: the Fed's decisions indirectly shape the cost of servicing that debt, through interest rates. Luna: Right, because the ten-year Treasury is at 4.7 percent, and that's tied to the Fed's policy path, isn't it? Lucas: Exactly. And the federal funds rate is at 3.63 percent. So the Fed isn't just ignoring the debt—they're actively making it more expensive to carry. Treasury Secretary Bessent just said there's a 'very good chance' the deficit has peaked, but the debt keeps rolling over at higher rates. Luna: So what does the Fed actually watch instead? I mean, they must have some view on fiscal stuff. Lucas: They watch the transmission to inflation and growth. The debt matters only insofar as it affects aggregate demand or inflation expectations. Right now, with core PCE at 2.3 percent year-over-year, they see inflation cooling, so they don't need to tighten to offset fiscal stimulus. Luna: But isn't there a risk that all this debt issuance just floods the market and pushes yields higher, forcing the Fed to react? Lucas: That's the classic crowding-out argument, and it's worth taking seriously. The Treasury has to auction a lot of paper, and if buyers demand higher yields, that filters into mortgages and corporate bonds, which slows the economy. But the Fed's view is that it's manageable as long as inflation stays in check. Luna: So they're effectively saying, 'We'll deal with the consequences if it becomes a problem, but the debt itself isn't a problem.' Lucas: Pretty much. And there's a subtle way the Fed actually helps: their own balance sheet. They're still holding a big chunk of Treasuries from the pandemic, and when they let those roll off—quantitative tightening—they're effectively letting the private sector absorb that debt. But they've been slowing that pace recently. Luna: Interesting. So the Fed's balance sheet decisions are intertwined with fiscal policy, even if they don't say it out loud. Lucas: Absolutely. And the ten-year breakeven inflation rate, which is what the market expects inflation to average over the next decade, is sitting at 2.3 percent. That's basically right at the Fed's target. So the market isn't worried about the debt causing an inflation spiral. That gives the Fed cover to stay put. Luna: So what happens if inflation picks up again? Would they have to raise rates and make the debt even more expensive? Lucas: That's the nightmare scenario. If the Fed had to hike while the debt is this large, the interest bill would balloon. But look at the data: real GDP growth is only 1.5 percent in the second quarter, and job openings are down to 7.36 million. The economy is slowing. That's deflationary pressure, not inflationary. Luna: So the Fed is more worried about slowing growth than about the debt. That's a shift from the old days, right? Lucas: It is. In the 1980s, Paul Volcker basically had to crush inflation by raising rates to double digits, and that made the debt service a huge burden. But now, with inflation running below target in some measures—core PCE is at 2.3 percent, and the PCE deflator is actually down quarter-over-quarter—they have room to be patient. Luna: But the debt is at forty trillion. Doesn't that at least limit their options? Like, they can't cut rates too aggressively because that might spook bond markets? Lucas: Right. The bond market is the ultimate disciplinarian. If the Fed cuts rates while the debt is exploding, investors might demand higher term premia to hold long-dated bonds. That's why the ten-year yield is at 4.7 percent even though the funds rate is at 3.63. There's a premium for all that issuance. Luna: So the Fed is kind of stuck between a rock and a hard place. They can't ignore the debt entirely because it affects bond markets, but they can't make it their mandate either. Lucas: Exactly. And that's why you hear Trump complaining about rates being too high, and Bessent saying the deficit might peak. The politics are messy, but the Fed's job is to look through it. Luna: So if you're a listener trying to make sense of this, what's the one thing to remember? Lucas: The Fed doesn't target the debt, but it watches the bond market's reaction to it. The forty trillion matters because it influences long-term yields, which feed into the economy. But the Fed's hands are tied by inflation and employment. Luna: That's a good way to put it. It's like the elephant in the room that everyone sees but the Fed chooses to walk around. Lucas: And part of the reason they can walk around it is that the economy is still growing, even if slowly. Real GDP is up from last quarter, unemployment fell to 4.1 percent, and initial jobless claims are at 206,000—that's a strong labor market. So the debt isn't an immediate crisis. Luna: It feels like we've been saying 'not an immediate crisis' for years. At some point, doesn't the bill come due? Lucas: That's the million-dollar question, and no one knows. But the Fed's stance is that they'll deal with it when it comes. For now, they're watching the data, and the data says inflation is cooling and growth is moderate. Luna: So, Lucas, you know what's interesting? We talk about this macro stuff every day, and I feel like I get it a little better each time. But I also realize how much of this depends on people like us explaining it clearly. Lucas: And that's exactly why we do this show. It's ad-free, funded by listeners who find it useful. And if you've gotten something out of it, a couple of dollars a month genuinely keeps these going. Luna: Yeah, it's like buying us a coffee. You can do that at buy me a coffee dot com slash fexingo. It's a small thing but it makes a real difference. Lucas: And it helps us keep doing this deep dive into the numbers. So, back to the debt: Bessent also mentioned a Treasury buyback operation that could be more than four billion dollars. That's a tool they're using to manage the maturity profile. Luna: Wait, so they're buying back old bonds? How does that help with the debt? Lucas: It's about smoothing out the maturity wall, not reducing the total debt. By buying back less-liquid older issues, they can manage the yield curve and reduce volatility. That's a way to keep the market functioning smoothly without changing the net supply. Luna: So it's like a technical tool, not a solution to the debt. Lucas: Exactly. And it shows that the Treasury is being proactive, but the fundamental issue remains: the debt is growing, and interest rates are higher than they were a few years ago. The average cost of servicing the debt is creeping up. Luna: So what should we watch for in the coming months? What would signal that the Fed can't ignore the debt anymore? Lucas: Watch the ten-year yield. If it starts to spike above five percent, that's a signal that investors are demanding more compensation for the debt. Also watch the term premium, which is a measure of how much extra yield investors want for holding long-term bonds. Right now, it's been low, but that could change. Luna: And if that happens, the Fed might have to tighten even if inflation is low, just to defend the dollar or something. Lucas: That's the kind of scenario that keeps Fed officials up at night. But for now, the data is on their side. Core PCE is at 2.3, unemployment is at 4.1, and the economy is growing at 1.5 percent. They can afford to be patient. Luna: So the debt is a slow-burning issue, not a crisis. That's a lot less scary than the headlines make it seem. Lucas: That's a fair takeaway. The headline number is dramatic, but the economic reality is more nuanced. The Fed is focused on the near-term, and the near-term looks okay. The question is how long we can keep kicking the can down the road. Luna: And that's a question for another day, I guess. Thanks for walking us through this, Lucas. Lucas: Always a pleasure. We'll keep watching the numbers.