On December 16, the Federal Reserve FOMC committee issued a statement on monetary policy following its scheduled meeting. It didn’t contain much new and the market shrugged it off. The Fed will keep interest rates at zero until inflation exceeds 2% for an extended period of time. The Fed has been talking about this policy since the summer of 2020 and it didn’t raise much comment; the nation was distracted with other news. Few have paused to consider what a sustained period of 2% inflation could do to government finances.

In the long-term, US real interest rates have averaged 3.8%; that is 3.8% above the level of inflation. Prior to the 2020 recession, they have been running between 2 and 2.5%. Let’s assume that the new equilibrium remains at the low end at 2%. The nominal interest rate for US government borrowing will then be 4%: 2% inflation plus 2% real interest rate. That’s not an unusually high rate by historical standards.

US government debt is currently $27.5 trillion. At 4%, the annual interest expense on the debt will be $1.1 trillion. Federal tax revenue is running at $3.5 trillion: interest expense will eat up 31% of federal tax revenues!

Actually, that’s a too optimistic way of looking at it. Of the $3.5 trillion in federal tax revenues, $1.3 trillion comes from payroll taxes that are earmarked for Social Security and Medicare. Only $2.2 trillion of revenues go into the general government budget; interest expense will eat 50% of those revenues. The federal government will be left with only $1.1 trillion to spend. To put this number in perspective, the federal government is spending $4.3 trillion in 2020. It will need to cut expenses by 73% or it will have to find some other way to plug the hole.

The Social Security system used to run surpluses as workers contributions exceeded retirees’ benefits. Unfortunately, Social Security tax revenue will fall below Social Security payouts starting in 2021. Oops. We can’t get help from there.

What about Medicare? I have bad news. The Medicare Trust Fund will become insolvent in 2024.

Well, maybe we can raise taxes. Alas, federal tax revenues have been stuck in the range of 15-17.5% of GDP since World War 2. Even when marginal income tax rates reached 90% in the 1960s, tax collections barely budged. The US has never in its history been able to raise more than 20% of GDP in taxes. Big part of the reason is that state and local taxes are collectively as big as federal taxes, so the total tax burden is much closer to 40%. Raising it any further won’t work.

Government revenues to GDP

What is likely to happen? It doesn’t take a PhD in economics to figure out the most likely solution: the government will print more money to paper over the hole in the budget. All the newly created money will increase inflation, which will lead to higher interest rates, which will make the deficit worse. There is a point of no return beyond which the government loses control of its finances.

Nobody knows for sure where that point lies. But raising inflation to 2% or higher is certainly a way to find out.