The Coming Interest Rate Effect

On March 5th, 2013, posted in: Economic News, Newsletter by

Most of the Hi-Fos (high information voters) have been watching the sequestration dance in Washington with a modicum of interest. After the threats of starvation, mass killings and who knows what else, the deadline passed and the President got hoisted on his own petard. Meaning, it was his idea and it backfired on him. The fiscal situation is still messy; deficits and spending are out of control but what is not mentioned is spending as a percent of GDP is declining as well as the annual budget deficit. According to the GAO, the budget deficit reached an apex of $1.4 trillion in 2009. The current forecast is for the deficit to be $830 billion, or about 5% of GDP. Spending has fallen too, from more than 25% of GDP to 22%.

Now this is not the solution. But it is a beginning. The problem is even if deficits keep falling in the next few years, spending on Social Security and Medicare is going to skyrocket. Those programs must be reformed. If not, the economy will eventually be swamped with either too much debt or growth-killing tax hikes or both.

If you are like most economic hypochondriacs, there are some bears who have been harping on different aspects of economic chaos. Are Bernanke’s artificially low interest rates covering up serious problems? What happens when those rates go back to normal? Will interest costs soar and all of the economic progress gained since 2007-8 disappear? Not sure anyone really knows the answers to those questions.

Right now the federal debt is $16.5 trillion. If interest rates rise 1% there will be an extra $165 billion added to the US annual interest payments. Put that in perspective. The net interest for the federal government in 2012 was $223 billion.

 

Is this really the problem the doom and gloomers portent? Interesting fact, the relevant debt for calculating how much interest will go up is NOT $16.5 trillion debt. That amount also includes debt the government owes itself  (like for the Social Security Trust Fund) plus debt owned by the Fed to the treasury. Exclude these from the calculation and there is roughly $10 trillion at risk. So a 1% rise in rates would add $100 billion to the deficit, not $165 billion. Still a big number but only about 0.3% of GDP.

Another factor is how to measure aggregate interest. It is wrong to assume “normal” rates must be many multiples of what the Treasury now pays. It is true New Treasuries are paying very low rates. But much of the Treasury debt was issued back when rates were much higher. The average interest rate on marketable debt is now around 2%. The Fed is projecting short rates will eventually go back up to about 4% average while long-term rates might go to 4.5%. So assume the Treasury will eventually have to pay 4.25% instead of 2%. If so, net interest will rise to 3% of GDP (from the current 1.5%), This is about the same percentage as the 1980s and 1990s, when the economy was doing quite well.

A Last and final point is if interest rates are rising, presumably the economy will be getting stronger. This would equate to higher tax revenues. So a boost in interest costs should be partially offset by higher tax revenue. Consider this. An extra 1% rise in real GDP growth for only one year adds about $30 billion per year in revenue.

Some suggest interest rates may go even higher than the 4% the Fed now thinks will happen. But with an average debt maturity of about 5 years, it will take time for these higher rates to actually materialize. This gives the economy time to recover. With higher tax rates, a 4% interest rate has a net cost to the government of about 2.5%.

This is NOT to say things are fine. The country’s fiscal situation has challenges to be sure. But perhaps worrying about what will happen if the economy is doing better and the Fed is finally raising rates is not one of them. The pouting pundits of pessimism are probably over-reacting once again.

This chart lists some of the more important economic indicators. ISM above 50 means the economy is expanding. Falling factory orders and productivity are indicators of softening. However, they could be affected by weather, business cycles or other extraneous events.

 

Index

Month

Consensus

Previous

Actual

Date Expected

Time

ISM Non Mfg Index Feb

55

55.2

Mar 5 9:00 am
Factory Orders Jan

-2.2%

1.8%

Mar 6 9:00 am
Unemployment Claims Mar-2

355k

344k

Mar 7 7:30 am
Q4 Non Farm Productivity Q4

-1.6%

-2.0%

Mar 5 7:30 am
Q4 Unit Labor Costs Q4

4.3%

4.5%

Mar 5 7:30 am
Int’l Trade Balance Jan

-$43bil

-$38.5bil

Mar 5 7:30 am
Consumer Credit Jan

$15.0bil

$14.6bil

Mar 5 2:00 pm
Non Farm Payrolls Feb

$160k

$157k

Mar 8 7:30 am
Private Payrolls Feb

$167k

$166k

Mar 5 7:30 am
Manufacturing Payrolls Feb

$8k

$4k

Mar 5 7:30 am
Unemployment Rate Feb

7.9%

7.9%

Mar 5 7:30 am

 

 

This information is compiled by Guy Baker from an assortment of news feeds including First Trust, Yahoo Finance, Bloomburg and others. This information is intended to be informational only. This newsletter contains forward-looking statements about various economic trends and strategies. You are cautioned that such forward-looking statements are subject to significant business, economic and competitive uncertainties and actual results could be materially different. There are no guarantees associated with any forecast and the opinions stated here are subject to change at any time and are the opinion of the individual strategist. Data comes from the following sources: Census Bureau, Bureau of Labor Statistics, Bureau of Economic Analysis, the Federal Reserve Board, and Haver Analytics. Data is taken from sources generally believed to be reliable but no guarantee is given to its accuracy.

 

 

 

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