US debt sustainability and central bank balance sheet dynamics

The US fiscal deficit and national debt are both projected to grow until 2050. The Congressional Budget Office (CBO) first warned in 2023 that, during the next 30 years, the US “faces a challenging fiscal outlook” that “exceeds any previously recorded level”.

The federal budget deficit is predicted to “increase significantly” from 5.6% of GDP in 2024 to 8.5% by 2054, according to the latest CBO projections. At the same time, GDP growth is expected to fall from 1.8% per year to 1.6%.

Meanwhile, the US Federal Reserve System’s unrealised mark-to-market losses exceeded $1 trillion in 2024, according to its second-quarter report. In initiating quantitative tightening (QT) and raising interest rates at the same time, it was the architect of its own balance sheet losses.

The longest and deepest Treasury yield-curve inversion in history emerged in July 2022, shortly after the Fed increased its policy rate by 25 basis points above market expectations and began reducing the size of its balance sheet in June of that year.

“Debt is sustainable as long as growth is higher than interest payments on debt-to-GDP,” an official from a multilateral lending institution tells Central Banking, speaking on condition of anonymity. “That’s where I think Uncle Sam may have an issue.”

Many countries are still emerging from a series of historic shocks, such as the Covid-19 pandemic, which resulted in higher public debt, a significant amount of which was bought by central banks in primary and secondary markets, many using unconventional monetary polices to maintain financial stability and prevent market dysfunction.

To provide a sense of the scale of debt held by reserve currency-issuing central banks, in 2023 YiLi Chien and Ashley Stewart of the Federal Reserve Bank of St Louis looked at four major reserve currency central banks and their balance sheets relative to GDP. The Fed’s balance sheet relative to GDP increased from 6.4% to 34.8% between Q1 2007 and Q1 2021. The Bank of England’s (BoE’s) and the European Central Bank’s (ECB’s) balance sheets rose from 5.3% to 44.3% and from 12.6% to 60.3%, respectively. Meanwhile, the Bank of Japan’s exploded from 22.2% to 136.7%. 

Since the global financial crisis that began in 2007–08, quantitative easing has primarily been used as a tool by advanced-economy central banks, which bought government bonds in secondary markets. But, during the pandemic, for the first time, emerging-market central banks purchased government debt at scale. Indeed, the governors of South Africa’s and Russia’s central banks underscored the risks posed to central bank balance sheets and of fiscal dominance during an International Monetary Fund (IMF) panel in 2021.

Central banks hold the government debt they bought during the pandemic on the asset side of their balance sheets. To do this, they increased the monetary base – or the narrow measure of the money supply (M0), which is the currency the public holds and the bank reserves – on the liability side.

“With such large balance sheets, raising the policy rate could impose a high cost on the central banks themselves,” Chien and Stewart warned last year, pointing to the rates paid on banks’ reserves. “In turn, this could impact the revenue of their countries’ respective governments,” they argued. If central banks generate little or no profit to transfer as part of their profit-sharing agreements, this could necessitate further government borrowing. In a low interest rate environment, government borrowing can be offset by profit transfers. 

“This is not just an imaginary accounting problem, but can have a real impact on an economy,” Aleš Michl, governor of the Czech National Bank – no stranger to operating with negative equity – tells Central Banking.

“Even though our cumulative loss does not prevent us from implementing monetary policy focused on price stability, the losses incurred by the central bank translate into profits for market participants,” Michl says. To make profits in the long term, “we need to reallocate our assets, 98% of which are foreign exchange reserves, so the expected returns more than cover the expected costs of monetary policy, of interest rates on commercial bank reserves”.

The Fed, meanwhile, has suspended weekly remittances to the Treasury. Though since autumn 2022, transfers periodically resumed during 2023 and the first half of 2024, net excess earnings would need to reach more than $40 billion before payments are reinstated. Realised losses hit $200 billion in October 2024.

The US government has, for the time being, lost the Fed as a source of income, just as US debt is fast approaching $36 trillion. However, remittances from the Fed to the Treasury between 2011 and 2021 totalled less than $1 trillion, amounting to between $5 billion and $10 billion per month. A larger factor at play regarding the US government’s ability to continue borrowing may be QT, and the overall supply of US Treasuries on the market.

At around the same time the Fed returned to operating at a loss in June 2024, it also reduced the runoff pace for Treasury securities, cutting the amount it allows to mature from $65 billion to $25 billion per month, while keeping mortgage-backed securities runoffs at $35 billion.

Pablo Guidotti, dean of the School of Government at Argentina’s Torcuato Di Tella University, tells Central Banking that “the fiscal deficit in the US and the growth of debt is increasingly falling on the domestic market and on domestic US investors”. The co-creator of the Guidotti-Greenspan reserve adequacy ratio observes that the proportion of US Treasury debt held internationally “has fallen significantly to almost one-third from being more than half”, just before the financial crisis.

Indeed, the CBO refined its long-term outlook in 2023 from saying “large and sustained deficits” will “lead to high and rising federal debt that exceeds any previously recorded level” to “federal debt held by the public far beyond any previously recorded level”. This raises questions around whether the US domestic market can or is willing to absorb US debt to meet the CBO’s projections.

Speaking to Central Banking on October 21, Chien also highlighted a paradox facing the US: the Fed is currently engaging in QT, meaning it is no longer purchasing additional debt beyond its existing holdings. Meanwhile, the federal government continues to run a large deficit, which requires issuing more debt. “Consequently, long-term government bond yields could rise as the Fed begins to lower short-term rates.”

For reserves-holding central banks whose interest rates are lower than the Fed’s, there are further risks to the asset side of the balance sheet under net foreign reserves. “Emerging markets have had almost three years of uninterrupted outflows,” says Guidotti. “That is totally unprecedented compared with previous periods.”

Chien counters that central banks with lower interest rates than the Fed’s “can borrow cheaply domestically, so they can earn excess return all the time” on US Treasuries to accumulate foreign reserves.

For reserve-holding currencies with interest rates higher than those of the Fed: “You always pay a spread to treasuries as an emerging market,” a senior adviser to a global systemically important bank (G-Sib) says. “The consequences of that for your country are that you need to bring in dollars to pay the debts you have incurred, or you need to run a smaller budget deficit or a bigger budget.”

Guidotti adds: “An increase in Treasury volatility of yields reflects negatively on the spreads that emerging markets have to pay.”

For reserves managers with higher local interest rates and growing domestic debt, their problems are compounded. While foreign direct investment may pivot back to emerging markets as the Fed begins an easing cycle, up until this point, where there are foreign investors, “higher debt means higher external debt, which means you need to build up your reserves”, says the official from the multilateral lending institution. “Countries know, when debt payments are high and your reserves are low, there is a speculative attack.”

Meanwhile, about two-thirds of countries still peg their currences or otherwise manage the exchange rate. IMF analysis for 2018–21 reveals that the average monthly net FX intervention as a percentage of GDP ranged between around 0.5% to 0.75% for these central banks, though some with floating exchange rates also fell into this bracket.

In terms of debt, Central Banking analysis shows that in 2022 – the latest year for which IMF data is available – the number of countries with a debt-to-GDP ratio higher than 100% rose to 21, up from 14 in 2019, after peaking at 28 in 2022. Notably, the number of countries with no data available has also increased in that time from four to 12, and now includes Afghanistan, Lebanon and Russia, where geopolitical risks painfully materialised.

There are a number of reserve adequacy measures. Reserves are considered to be adequate under the IMF’s Assessing Reserve Adequacy (ARA) metric if they are between 1 and 1.5. IMF data for 2023 shows reserve adequacy is lower than 0.5 for 12 countries and less than 1 for an additional 13, including China. The ARA includes M2 to measure balance of payments risks, including terms-of-trade shocks. M2 is money and assets that can be easily converted to cash, other than those of the central government. ARA is adjusted if the country is dollarised, if it has capital controls or if it is a commodity exporter or importer. Applying the widely used Guidotti-Greenspan ratio, which measures foreign reserves divided by short-term debt of up to one year, 19 countries fall below reserve adequacy, measured as 1. Twenty-four countries have no data for one or both measures.

In the eurozone, government bond purchases created a “sizeable increase” in “already large balance sheets”, wrote Charles Wyplosz, an emeritus professor of international economics at the Graduate Institute in Geneva, in his European Parliament-commissioned report Big central banks and big public debts in 2023. Where government bond purchases became frequent after the financial crisis and when policy rates were already at their effective lower bounds, the lines between fiscal and monetary policy became blurred. The subsequent scale of asset purchases after 2019 “intensified links between fiscal and monetary policies”, wrote Wyplosz. “Corrective action must not wait, if only because other shocks may again unexpectedly occur.”

Wyplosz tells Central Banking that large amounts of public debt “can worry the market and can trigger a crisis”. Market participants tend not to “worry too much” about the part that is in the hands of the central banks “until you start talking about QT”.

“What we’ve been seeing now for a couple of years, is the extreme prudence of central banks about carrying out QT, because this would put significant amounts of government debt back on the market, and central banks are worried that would increase the public debts of largely indebted countries,” Wyplosz explains.

Wyplosz’s recommendation is that the ECB should issue central bank bonds to shift public debt onto its balance sheet. It is during QT that Wyplosz envisages that instead of selling government bonds, the ECB would issue bonds that would be interchangeable on the market. “It does not affect the budget of the aggregated public sector. It is just where losses or profits appear,” says Wyplosz. 

While central banks have traditionally issued debt to inject liquidity into the financial system, in Wyplosz’s proposal, the composition of public sector debt would change but there would be “no impact on the money supply”. In a possible wider application, “what is important, of course, is to preserve the independence of central banks, because central banks are constantly, immediately, capitalising,” says Wyplosz.

One example of a central bank that regularly issues debt, though for different policy reasons, is the BoE, which for the past 25 years has issued securities – denominated first in euros and more recently in US dollars – to finance its own foreign currency reserves. Moreover, when the BoE suffers losses on its quantitative easing portfolio and some other liquidity facilities, the government automatically transfers money, which creates further fiscal pressure in the UK. Jamie Long and Paul Fisher issued a BoE working paper in April proposing central banks retain more profits when capital is low and “function as an income-generating asset for the government when capital is high”. This should help the BoE stand ready to act as a “credible and financially independent central bank”, they argue.

During the pandemic, the Central Bank of Chile initiated buyback of its own securities to inject liquidity, and the Bank of Thailand (BoT) bought BoT bonds following a government bond sell-off, triggered by the global ‘dash for cash’. The Swiss central bank also issues short-term debt to create a pseudo money market for financial intermediaries not allowed in the money market.

The majority of central banks that participated in Central Banking’s Benchmarking monetary policy 2024 report said they have the power to issue debt for monetary policy purposes (77% of 43 central banks).
 

Asked whether any pressure from Congress on the Fed to resume interest payments and stop buying public debt would in fact run counter to its interests, Chien says it depends on the perspective towards public debt. “You can see the central bank and the government as separate” or, because many central banks transfer profits back to the government, view “the central bank balance sheet together with the government balance sheet”.

The Fed’s stated policy is to keep its balance sheet outsized, at least for the foreseeable future. “To ensure a smooth transition,” the Federal Open Market Committee announced in May 2022 that it “intends to slow and then stop the decline in the size of the balance sheet when reserve balances are somewhat above the level it judges to be consistent with ample reserves”. The Fed is currently in an asset-driven floor system, due to its post-pandemic purchases. “However, we are running off our asset holdings to return to a liability-driven floor,” Federal Reserve Bank of Dallas president Lorie Logan told the ECB Conference on Money Markets 2023. By establishing a liability-driven floor, the Fed intends to meet banks’ demand for reserves but supply no excess reserves.

While, in Chien’s view, the US yield-curve inversion seen since 2022 is beginning to correct and the perceived likelihood of a recession is receding, the senior adviser to the G-Sib says this recession signal means emerging markets’ costs of funding may increase further due to Fed cuts.

In any case, Guidotti says: “In the future, I think there is a significant challenge for US fiscal policy to regain sustainability.”