The Independent Market Observer

4/26/13 – The Real Spending Crunch: When the Fed Exits

Posted by Brad McMillan, CFA®, CFP®

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This entry was posted on Apr 26, 2013 9:56:53 AM

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We’ve been talking about how the U.S. real economy, despite a second-quarter slowdown, continues to grow. The Fed by and large agrees, with several governors weighing in over the past couple of weeks to say that they see a sustainable recovery in place and that it’s time to start thinking about when and how to begin pulling back. You might be forgiven for thinking “Hooray!” After all, isn’t sustainable growth what we’ve been working toward for the past five years?

Although we do seem to have sustainable growth from multiple sources—housing, autos, and energy, among others—much of that growth is driven by current low interest rates, especially in housing. When the Fed starts pulling back, there is a reasonable possibility of higher interest rates, which will at least slow that growth.

The much bigger problem arising from higher interest rates, though, will be the federal debt. Not the deficit, the debt. The deficit continues to decline, and, although it’s still way too high, with the resumption of growth and the onset of sanity in Washington, D.C., we’re making progress toward responsibly reducing it. The first step when you’re in a hole is to stop digging, and we are doing that.

Nonetheless, we remain in a hole. The interest payments on the accrued federal debt, even at today’s historically very low interest rates, are a meaningful percentage of GDP. If interest rates rise even a bit, the increase in interest payments may meaningfully increase the deficit.

As I have written before, the fixed income markets suggest that we probably won’t face higher interest rates in the short term. The Fed, for example, isn’t talking about initiating an exit process until later this year, at soonest; even then, it will start by removing some of the extraordinary stimulus, such as bond buying, rather than actually raising target rates. Moreover, history suggests that interest rates following a financial crisis can remain low for decades. The Fed is thinking about the exit, though, and that means we have to as well. Ending the stimulus programs means the market may start pricing in interest rate increases.

The problems we currently face are the weak economy and the deficit. The weak economy is slowly healing. The deficit is at least being discussed. In my opinion, the next problem will be the debt, and rising interest rates will exacerbate it.

To dig out of the debt hole, we will need to do one of two things—either run a surplus, or grow the economy faster than the debt, which would mean reducing the deficit to less than, say, 2 percent of GDP. Either one will require much larger tax increases or spending cuts than anyone is now talking about.

Current plans, which discuss the deficit as a percentage of GDP, implicitly assume the current low interest rates will continue—which is reasonable over the near to medium term, although not guaranteed. What they don’t do is factor in the effects of increasing interest costs on the federal budget as rates rise.

This will be our next dilemma. Solving the problems in the real economy and reducing the deficit don’t get us out of the woods. They just buy us the right to move on to the next phase of the challenge.

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