Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / Why the Fed Watches the Debt Ceiling's New Math
Transcript
- Lucas: So the U.S. national debt just crossed forty trillion dollars, and the Fed is watching that number more closely than you'd think. It's not just about fiscal policy anymore — it's about how much room the Fed has to move rates without blowing up the government's interest bill. Luna: Forty trillion is a big round number, but what does it actually mean for the Fed's day-to-day decisions? Lucas: Well, the Fed Funds rate is sitting at 3.63 percent right now, and the ten-year Treasury is yielding 4.74 percent. When the government has to roll over that debt at these rates, the interest cost becomes a real constraint. Some economists are calling it fiscal dominance — when the Fed can't hike aggressively because it would spike the cost of servicing the debt. Luna: So the Fed is basically walking a tightrope between fighting inflation and not bankrupting the Treasury. Lucas: Exactly. And you can see that tension in the latest PCE data. Core PCE came in at 130.3 for June, up from 130.09 the month before. That's still above the Fed's two percent target, and the ten-year breakeven inflation rate is 2.34 percent. So inflation is sticky, but the Fed can't just crank rates up like it might have a decade ago. Luna: I remember when people talked about the Fed being independent. How independent can you be when the government's borrowing costs are tied to your decisions? Lucas: That's the million-dollar question. And it's why Treasury Secretary Bessent's recent moves in the bond market have gotten so much attention. He's been pushing for Treasury buybacks — essentially the government buying back its own bonds to manage the yield curve. He says the operation could be more than four billion dollars. Luna: Wait, the Treasury buying back its own debt? Doesn't that just add to the debt? Lucas: Not exactly. It's more like refinancing — buying back older, higher-coupon bonds with proceeds from issuing new ones at lower rates. It's a tool to smooth out the maturity profile and potentially lower the average interest rate on the debt. The Fed watches this closely because it can affect money market rates and bank reserves. Luna: So it's like a household refinancing their mortgage to get a lower rate. But with forty trillion dollars, every basis point matters. Lucas: Right. And the Fed's own tool, interest on reserve balances, is at 3.65 percent. That's the rate it pays banks to hold reserves, and it's a key lever for controlling the fed funds rate. When the Treasury does buybacks, it can drain or inject reserves, which the Fed has to offset. It's a coordination dance. Luna: And if the coordination breaks down? What happens? Lucas: You can get repo market stress, like we saw in 2019. That's when short-term funding rates spike because banks don't have enough reserves. The Fed had to step in with temporary operations then. So now it's watching Treasury's buyback plans very carefully to avoid a repeat. Luna: So the Fed is essentially a backseat driver in the fiscal car, watching the Treasury's every move. Lucas: That's a good way to put it. And that's why the debt ceiling math matters beyond the political circus. When the government hits the ceiling, the Treasury has to use its cash balance and extraordinary measures, which can slosh around reserves and affect money markets. The Fed has to be ready to respond. Luna: I've heard Bessent say the deficit might have peaked under Trump. Is that even plausible with forty trillion already on the books? Lucas: He said there's a 'very good chance' the deficit has peaked. That's a political statement as much as an economic one, but structurally, if rates stay around here and tax revenues hold up, the deficit could start to shrink relative to GDP. But the debt stock is still growing, and the interest cost is a massive line item. Luna: So even if the deficit shrinks, the interest payments are like a rising tide that never goes out. Lucas: Exactly. And that's why the Fed is watching the ten-year yield so closely. It's up to 4.74 percent, which is above the ten-year breakeven of 2.34 percent. That gives you a real yield of about two point four percent — that's the real cost of borrowing for the government, and it's high by historical standards. Luna: I guess that's why the Fed is so cautious about cutting rates. If they cut too fast, inflation might reignite, but if they hold, the interest burden keeps growing. Lucas: Right. And there's a structural issue here that some economists call 'secular stagnation' — a persistent lack of demand that keeps real rates low. But now we have a situation where real rates are actually elevated because of the debt supply. That's a new dynamic. Luna: It's like the Fed is stuck between a rock and a hard place, and the rock is made of Treasury bonds. Lucas: Ha, exactly. And that's why the Fed is so focused on communication. Every FOMC statement is parsed for any hint about how they're weighing these risks. But of course, we can't just talk about the Fed without acknowledging that this kind of analysis is exactly what makes our show worth making. Luna: Oh, for sure. If you're getting value from these episodes, you know, if walking through the economy with us has made something click, that's the kind of thing that keeps us going. Lucas: And honestly, if today's episode was worth a coffee to you, that's the link — buy me a coffee dot com slash fexingo. It's the smallest possible ask that lets us keep doing this ad-free. Luna: Every cup keeps the lights on. And speaking of lights, let's go back to the Fed's toolbox — what else can Bessent try besides buybacks? Lucas: Well, the headlines suggest his bond gambit hasn't fully calmed markets yet. But there are a few things. He could extend the average maturity of the debt by issuing more long-dated bonds, which would lock in rates but maybe push long yields higher. Or he could lean on the Fed's reverse repo facility to manage short-term rates. Luna: But wouldn't issuing more long bonds just add to the supply pressure that's already pushing yields up? Lucas: That's the trade-off. If you issue more long bonds, you're crowding out private investment and pushing yields up. But if you stay at the short end, you're more exposed to refinancing risk. The Fed's job is to make sure this doesn't spiral into a funding crisis. Luna: It feels like the Fed is the fire department, and the Treasury keeps throwing a few matches into the pile. Lucas: A bit. But remember, the Fed also has a mandate for maximum employment and price stability. If the debt situation gets in the way of that, they have to act. The question is, how much can they do without making the fiscal situation worse? Luna: So what are you watching in the next few months that would tell us if this is working? Lucas: I'd keep an eye on the two-year yield. It's been a hot signal for the Fed's expected path. And the August jobs report — that's always a big one for the Fed. Plus, any hints from Bessent on the buyback operation's scale and timing. If he goes bigger than four billion, that could be meaningful. Luna: Do you think the Fed will actually cut rates this year, or are we looking at another hold? Lucas: It's a coin flip, honestly. The effective fed funds rate is at 3.63 percent, and markets are pricing a little bit of easing, but not much. The core PCE is still above target, and inflation expectations are anchored around two point three four percent. If the data stays sticky, they might hold until that breaks lower. Luna: So the debt ceiling and the Fed are just two sides of the same coin. Lucas: Exactly. And that's the real story here. The Fed can't ignore the fiscal reality. Forty trillion dollars is a big number, but the real issue is the interest cost that number implies. As long as the debt grows faster than the economy, the Fed's independence is going to be tested. Luna: It's a strange situation — the Fed has to be the adult in the room, but the room is on fire. Lucas: Yeah, and that fire is why every FOMC meeting feels like a high-stakes drama now. But for now, the Fed is holding steady, and the Treasury is trying to manage the curve. We'll see how the August numbers change the picture.