The Fed’s Unpublished Outlook for Interest Rates

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.

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About Tom Lindmark 401 Articles

I’m not sure that credentials mean much when it comes to writing about things but people seem to want to see them, so briefly here are mine. I have an undergraduate degree in economics from an undistinguished Midwestern university and masters in international business from an equally undistinguished Southwestern University. I spent a number of years working for large banks lending to lots of different industries. For the past few years, I’ve been engaged in real estate finance – primarily for commercial projects. Like a lot of other finance guys, I’m looking for a job at this point in time.

Given all of that, I suggest that you take what I write with the appropriate grain of salt. I try and figure out what’s behind the news but suspect that I’m often delusional. Nevertheless, I keep throwing things out there and occasionally it sticks. I do read the comments that readers leave and to the extent I can reply to them. I also reply to all emails so feel free to contact me if you want to discuss something at more length. Oh, I also have a very thick skin, so if you disagree feel free to say so.

Enjoy what I write and let me know when I’m off base – I probably won’t agree with you but don’t be shy.

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