For years, there’s been little incentive to stop the borrowing. Interest rates are at or near record lows, so the economy keeps chugging along. Low rates incentivize more borrowing so consumers can keep buying things. The stock market keeps going up, so investors are happy. Best of all, there’s been no financial penalty for doing this. Up until recently, inflation has generally been in the 1-2% range for years. If the government can borrow trillions of dollars at historically low interest rates and see no meaningful increase in inflation, what’s the downside?
Well, that’s finally changed this year. Now there is a penalty in the form of 6% inflation rates that we don’t know how long will last. It doesn’t matter that it’s taken a unique set of macroeconomic circumstances to help trigger this. It still stings all the same. The chickens are finally coming home to roost and I fear that we’re about to find out exactly how deeply the Fed has been pinned back into a corner.
Powell and company have had ample opportunity to normalize financial conditions for years. Every time something happened, however, the Fed blinked and immediately walked back any progress that had been made. They tried to normalize conditions from 2016-2018 and managed to actually get the Fed Funds rate all the way up to 2.25%. Then the S&P 500 corrected by 20% in the 4th quarter of 2018 and the Fed turned dovish. The Fed Funds rate was back down to 1.5% by the end of 2019 before going all the way back to 0% when COVID hit.
Today, the Fed is in an increasingly tricky spot because of its failure to act coming out of the pandemic. The U.S. economy began its recovery in the 3rd quarter of 2020 and has been growing strongly ever since. In theory, the time to begin thinking about rate increases was about a year ago. Ideally, you’d want rate hikes to take place at the same time that growth is strong, so the economy is better equipped to handle tighter conditions. But the Fed (along with nearly every other central bank around the world) has continued to hold off tightening policy (or even tapering asset purchases). The Fed still isn’t expected to raise rates until at least the 2nd half of 2022. The ECB is unlikely to raise in 2022 at all.
The Fed now has to deal with two problems. The economy is slowing again. GDP growth in Q4 came in at 2%, well below expectations as the stimulus cash well has dried up, supply chains slowed production to a quick halt and rising inflation crippled spending power. The U.S. inflation rate is up to 6.2% and now the Fed is stuck. Does it raise rates in an attempt to contain inflation at the risk of slowing an already slowing economy even further? Does it keep conditions loose in hopes of re-stimulating growth and hope that inflation comes back down? It may quickly become an issue of choosing one but not both.
The Fed doesn’t want to (can’t afford to) let rates get too high. As it stands right now, the government will spend more than $300 billion for interest payments on existing debt alone. That represents 9% of all tax revenue collected. That’s with interest rates at historic lows.
We know that most of the government’s borrowing is done on the shorter-end of the curve. About ¼ of debt is in the form of ultra-short maturity bills and about ½ in intermediate-term notes. Just 14% of government debt would be considered longer-term.
That’s good for current interest payments but bad in the sense that this debt is vulnerable to rising rates. When it matures, it’ll need to be rolled into potentially higher interest debt. You can see the conundrum that exists if the Fed starts raising rates and the Treasury yield curve begins rising.
The average maturity on all government debt right now is a little over five years, the lowest it’s been in about a decade when the government issued a lot of short-term debt to counter the financial crisis. In a rare moment of prescience, the government has been raising more long-term debt, hopefully with the idea of taking advantage of today’s low rates for longer, but the government is still vulnerable to rising rates.
Given the current composition of government debt, every 1% increase in rates would add another roughly $220 billion to servicing costs.
With just a 1% increase, the government is spending more on interest than Medicaid. At 2%, it’s spending more than on national defense. At 3%, it’s spending about as much on debt interest as it is on Social Security.
The big tail risk event comes when government debt finally becomes unserviceable. That’s the point where the government won’t have enough money to pay for all that interest expense along with everything else it typically wants to spend on without running massive deficits, needing to raise taxes significantly across the board or somehow push interest rates back towards 0% again. Absent one of those happening, you go from the bad outcomes to the really bad outcomes - namely, bankruptcy and a default on U.S. government debt.
Regardless of which remedy you choose, it’s difficult to see how any of those happens without a huge correction in risk asset prices. As it looks today, it’s coming. The CBO is projecting that the U.S. government will run a trillion dollar budget deficit every year this coming decade. That’s assuming, of course, that it doesn’t unleash a massive stimulus package on the economy again during that time.
Figuring out how to tax billionaires or coming up with ideas, such as taxing unrealized capital gains, to address debt problems are minor solutions to what’s becoming a major issue. In the not-so-distant future, the government is going to need to make major changes to its spending addiction or suffer the consequences.
If you have any questions, feel free to use me as a sounding board CLICK HERE.
Kurt S. Altrichter, CRPS®
Fiduciary Advisor | President
Direct: 952.828.5336
Email: kurt@ivoryhill.com
—Written 11.21.2021.