Back Where We Started
Many of you may remember that this commentary began in 2010 amidst trillion dollar plus budget deficits, which led (at least in part) to the ensuing Tea Party reaction and a movement toward fiscal constraint in Washington. For several years, federal spending (at least on-budget spending) has been restrained by caps and offsets which required any additional appropriations to be compensated for by cuts in another part of the budget or tax increases. This regime was gamed from time to time, but by and large it held down government spending.
The recently-passed budget agreement, however, has smashed the caps and freed Washington from its spending rules. While technically the caps are supposed to be re-imposed in a few years, there is little doubt that they will be once again “temporarily” suspended when the deadline approaches—the same tactic by which the debt ceiling has been eviscerated. Estimates for trillion-dollar annual deficits are once again circulating, and the powerless rump of fiscal conservatives, their bona fides besmirched by their recent support of a budget-busting tax cut, can do little more than wrap themselves in their faded mantel of Responsibility and impotently rail against the evils of Big Government. It would seem that this year the Washington spring will bring business as usual along with the cherry blossoms.
But You Can’t Go Home Again
And yet, while the cycle repeats, it also advances. In fact, the government’s ability to embark on a new spree of carefree spending is somewhat more limited than in years past. This is primarily because the national debt has continued to expand even with the constrained spending of the last eight years, and the required interest payments on that debt have only remained manageable because of the low interest rate policy instituted by the Federal Reserve during the financial crisis of 2008. The average interest rate paid on the debt has gradually fallen as older, higher rate paper matured and was replaced by lower cost debt.
As a result, the federal government’s interest expense remained roughly constant from 2007 to 2015 even as the amount of debt outstanding doubled.
Now, however, the Federal Reserve has committed to raising interest rates (if for no reason other than to give themselves the ability to reduce them during the next economic downturn) and the path to higher rates leads to expanding payments on the debt. This will lead to a double whammy for interest expense—both the amount of debt and the average rate will be rising at the same time. If Fed hikes over the next few years were to return us to the 4% average of 2006-08 (the last period in which the central bank embarked on a sustained tightening path), we could see the interest payments on the national debt exceed $1 trillion annually by around 2020. While this path of increased overnight rates is admittedly unlikely, it does suggest that the Fed’s freedom to set higher interest rates in the future will run up against fiscal considerations. Without the credibility to fight consumer price inflation by raising the overnight lending rate (whether this actually leads to the desired outcome is unproven, but most people believe it to be so), the Fed’s mandate to maintain a stable monetary system will be called into doubt.
Please note that this conclusion is not intended as an entrée to the familiar scare tactics regarding the national debt– that the federal government is “going broke” or that the Treasury will not be able to finance its operations or any of the usual canards. The US government is a currency issuer and therefore not a typical debtor. All we are saying is that the Fed’s ability to take its familiar path—raising interest rates to “fight” inflation—has been eroded by the rising debt, and its future tactics will most likely involve something very different.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results.
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