Outlook for Interest Rates: The Fed's Unpublished Report

It would be pretty hard to come up with a number for the amount of pixels that have been expended discussing the impact of increasing budgets and budget deficits on future interest rates, it’s no doubt an astronomical amount. Little did we know that the Fed had already calculated the answer.

The Telegraph reports that Thomas Laubach, the Fed’s senior economist, figured out the answer in 2003:

Using historical examples for his paper, New Evidence on the Interest Rate Effects of Budget Deficits and Debt, Mr Laubach came to the conclusion that “a percentage point increase in the projected deficit-to-GDP ratio raises the 10-year bond rate expected to prevail five years into the future by 20 to 40 basis points, a typical estimate is about 25 basis points”.

The US deficit has blown out from 3pc to 13.5pc in the past year but long-term rates are largely unchanged. Assuming Mr Laubach’s “typical estimate”, long-term rates have to climb 2.5 percentage points.

He added: “Similarly, a percentage point increase in the projected debt-to-GDP ratio raises future interest rates by about 4 to 5 basis points.” Economists are predicting a wide range of ratios but Mr Congdon said it was “not unreasonable” to assume debt doubling to 140pc. At that level, Mr Laubach’s calculations would see long-term rates rise by 3.5 percentage points.

The study is damning because Mr Laubach was the Fed’s economist at the time, going on to become its senior economist between 2005 and 2008, when he stepped down. As a result, the doubling in rates is the US central bank’s own prediction.

So, if Mr. Laubach is correct, that implies a 10-year bond at something around 7%, which would put the 30-year mortgage rate in the range of 9%. You can do the rest of the math as far as credit cards, car loans, student loans etc. go. That wouldn’t be a terribly attractive environment for growth, would it?

But as the article points out, the far graver danger would be the implications for fiscal health of this country and others. The sheer cost of servicing and refinancing the mountain of debt that we’re currently accumulating would most likely overwhelm the economy. The revenues that would by necessity have to be raised to cope with the problem would be so punitive as to make them unrealistic.

If you want the scenario that describes the events that would most likely lead to default through outright repudiation or through inflation, this is it. Effectively, the study suggests that the very efforts we’re employing to save ourselves carry the seeds of our destruction. Maybe this explains why so many other countries gasp at our recovery measures, prefer to buy at the short end of the Treasury curve and worry about the value of their dollar holdings.

It would be helpful if the Fed could let us know if they still hold to this view. It’s possible that Mr. Laubach’s study was flawed or has been supplanted by some updated view, or perhaps they see a way out of the conundrum that’s not obvious to others. Whatever, a little sunshine on the topic would be welcome.

Comments

[Roger Knights:]

"Sunshine" has been superseded; the new buzzword is transparency.

Jul 06 05:29 PM

[MarvinMBA:]

Our currency and many others around the world are in trouble...hold onto gold and silver but I'm sure they will outlaw this if it gets out of hand like keep up with inflation...Marvin

Jul 06 06:20 PM

[austrian63:]

Tom,

Why would you expect the Fed to let "us" know what their forecast for interest rates are? Why would you expect any kind of honesty from a central bank whose primary attribute is obfuscation?

The results of Laubach's study are intuitive. With higher debt loads come higher soveriegn risk from slower growth that is the result of crowding out, a smaller private sector and less income and capital within the total economy, etc. What the U.S. government has done over the past 20 to 30 years has been done many times over by kings, emperors, ceasars and finally "democratically" elected leaders. We will get what we ask for. The final chapter is always devaluation of the currency whether it is the coin clipping of centuries past or increases in the fiat money supply via electronic debits of bank reserves and the printing press.

We will see stable interest rates for the the near term which will continue to convice the Fed and the Treasury that we are now in a new era in which money can be created and borrowed without any negative consequences. Call it the final bit of enabling that will bring us to an eventual currency crisis. It will happen. The only question is when.

Those who are students of history and economic fundamentals know that the cure for too much borrowing and consumption is not more borrowing and consumption in a world of scarce resources. Without capital accumulation an economy cannot prosper.

Jul 06 06:40 PM

[whidbey:]

Good topic not because your findings are correct, but because it is timely as hell to think about these questions. I think in my work that there is no single answer to the implications of national debt, but as someone has already pointed out, the conditions in which debt is incurred are at least as important as the possible impacts on interest rates. This economy is already weakened more than we know and its also radically out of balance on liquidity so an increase in interest rates will have uneven affects. But we do know this, there will be affects and they will not be good. How the policy makers can not know this is the most interesting question of all. They do not know the precise affects, but they know they will be irreversible, long lasting, and likely fatal to the economy as we know it. The correction coming this fall will be a blow few will recover from. I know, call my doctor for help, but - he agrees.

Jul 06 09:20 PM

[Moon Kil Woong:]

I think we will run out of anyone willing to buy our bonds a lot sooner than we find that we can't afford to pay our debt. Already the US is increasingly looking to easy ways out (let the Fed buy the excess) and most likely at typical metods of floating bonds with unattractive interest rates like the domestic bond drives similar to the WWII buy government bond initiatives exemplified by Clint Eastwood's "Flags of Our Fathers". If you can't do it for your economic best interest, do it for Uncle Sam. I'm sure that will fly in the current day and age lol.

It's hard enough just justifying paying your taxes anymore. After all most all infrastructure and government services (policing, fire departments, etc.) are paid by revenue bonds or regional, city, county, or property taxes. The Fed and State provide almost nothing to the average taxpayer yet hoards all the hard earned revenue for special interest redistribution and tax breaks for lobbyist's hard work.

Jul 06 10:20 PM

[cameroni:]

Yeah. The sunshine is gone alright. Lets look to Shadow Stats.


On Jul 06 05:29 PM Roger Knights wrote:

> "Sunshine" has been superseded; the new buzzword is transparency.

Jul 07 01:04 AM

[Doug Francis:]

As someone in the front yard with consumer clients highly influenced by daily mortgage rate fluctuations, a 9% 30-year mortgage will stop the real estate market in its tracks. Incomes would have to increase substantially and the resulting wave of inflation would be a further blow to the economy.

Jul 07 08:54 AM