The U.S. Federal government has been running deficits in the hundreds of billion

Question

The U.S. Federal government has been running deficits in the hundreds of billions of dollars which means that the U.S. Treasury is issuing hundreds of billions of dollars in new Treasury securities. If this is all you consider, what are the consequences for interest rates, spending financed by private borrowing, the money supply, the bond supply and inflation from this action alone?  While the U.S. has been running these massive deficits, what has been true about interest rates?  How do you explain this contradiction in interest rate effects and what are the big concerns going forward?

Explanation / Answer

Think of this like the most recent rounds of QE that the Government put in place.

Because the treasury is selling hundreds of billions in securities, this will likely raise interest rates. Interest rates stay low when the Fed buys back securities in an attempt to increase the money supply causing slight deflation in the interest rates. By reversing that strategy, it takes the opposite effect on interest rates. This will also increase the cost of private borrowing, it will decrease the money supply, bond supply will be increased (or lowered, depending on if they have sold at this point or not), and bond deflation will occur.

Interest rates have continually stayed low due to QE. By increasing the available money supply, the Fed has been able to keep interest rates in tact in order to increase spending, especially in the private sector. However, this is artificial. The second the Fed starts easing QE (i.e. selling those securities off, like in the instance of your question), interest rates will rise again because the money supply decreases, as does the bond supply.

You can use the Phillips Curve to explain this. The Phillips Curve theory is that as unemployment falls, inflation will rise. As unemployment has remained stagnant/increased, you've seen a lowered inflation cost, because workers don't expect higher wages, and the interest rate tends to follow inflation.

The concerns moving forward are that once interest rates begin to rise again (i.e. the selling of securities commences), the interest rates will rise, thus pushing potential investors out of the market.

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