Editor's note: Originally published at tsi-blog.com on February 8, 2016
There are things that monetary enthusiasts* such as me take for granted that are not widely understood. In an email discussion with a friend and fellow monetary enthusiast it occurred to me that the treatment of interest paid on the debt held by the Fed might be one of those things. That's the reason for this short post.
The Fed currently has about 4.2 trillion dollars of debt securities on its balance sheet, about 2.5 trillion dollars of which are US Treasury securities. The interest that the Fed earns on all of its debt securities - less a relatively small amount to cover the Fed's own operating expenses - gets paid into the General Account of the US Treasury. In other words, the interest that the US government pays on the Treasury bonds, notes and bills held by the Fed gets returned to the government. This effectively means that any US government debt held by the Fed is interest free.
An implication is that if government debt is held by the Fed, the interest rate on the debt is irrelevant. An interest rate of 20% is essentially no different to an interest rate of 1%, since whatever is paid by the government returns to the government.
Another implication is that when considering what-if interest-rate scenarios and the ability of the US government to meet its financial obligations under the different scenarios, the assumption should be made that the portion of the debt held by the Fed has an effective interest rate of zero. For example, let's say that at some point in the distant future the average interest rate on the US government's debt has risen to 10% and the Fed owns 80% of the debt. In this hypothetical - but not completely farfetched - situation, the effective average interest rate on the US government's debt would only be 2%.
The bottom line is that it's not so much the Fed's interest-rate suppression that benefits the US government, it's the fact that the interest-rate suppression is conducted via the large-scale accumulation of the government's debt.
* People who spend significant time every week tabulating/charting monetary statistics and poring over reports published by the US Federal Reserve and other central banks.