Andrew Stuttaford had a great piece yesterday about the growing unease due to the rise in interest rates. There are a few additional things worth noting on that front. He writes:
According to this report from the Peterson Institute, the average maturity of Treasury debt is 73 months, suggests that an opportunity has been missed, even if 73 months is ten months longer than the historical average over the last 20 years (it should be noted that, for technical reasons the “average” figure overstates the real maturity).
The missed opportunity here refers, I assume, to the fact that the federal government didn’t lock in low rates as it increased borrowing dramatically.
But here is the breakdown that people tend to ignore:
- 31 percent of debt matures within one year.
- 43 percent of debt matures within two years.
- 52 percent of debt matures within three years.
- 67 percent of debt matures within five years.
With debt to GDP at 94 percent, such a large amount of short-term debt, and no signs from Congress of being willing to reduce primary deficits, continued rising interest rates could become very messy, very quickly. That’s why Cochrane is correct that “the US should quickly move its debt to extremely long maturities.” If the existing maturity structure were longer, it would reduce the rollover costs.
Andrew then writes:
My suspicion is that, even if only intuitively, continuing inflation fears still account for some of what’s going on, but Kelly Evans, writing for CNBC, points the finger at another culprit, the growing government debt load and the cost of servicing it. It’s hard to imagine that investors are unaware of this issue.
He then quotes Kelly Evans, who explains that:
More than half of the budget deficit in the coming years is expected to result from higher interest payments. CBO thinks the deficit will average about 6% of GDP through 2033, with 3.1 points of that from interest payments on the debt. . . .
If we don’t quickly close the gap between spending and revenues, the debt load will keep growing, and interest costs will keep on rising, and the deficit will thus stay elevated, which grows the debt load even more.
And then:
Either D.C. needs to enact difficult policy changes that will drastically reduce the amount of future Treasuries coming onto the market, or a major new buyer (ahem, central banks?) needs to re-emerge.
I agree but there is something missing here. No mention of the impact that the rise in interest rates, the increase in interest payments, and growing deficits could have on inflation. I get it. A look at the CBO long-term projections has the debt to GDP go up to 180 percent in 30 years without any impact on inflation.
Yet that can’t be right. Think about it this way: If the Fed raises interest rates, it raises real interest rates, triggering a substitution effect (people swap consumption for saving, which reduces the timing of demand but not total demand). Without fiscal consolidation (i.e., increase in primary surpluses), the increase in rates will also have a positive wealth effect for those households that are net lenders to the government.
The only way to get a reduction of total demand, which will ultimately rein in inflation, is for the fiscal authority to implement fiscal consolidation, hence creating a negative wealth effect. Absent that fiscal contraction, inflation will rise.
The University of Virginia’s Eric Leeper explains the mechanism by which all this is happening in this paper, which in my opinion should be mandatory reading. He writes, “Evidently, routine impacts of monetary policy—for example, that higher interest rates reduce inflation—rest heavily on wealth effects.” Concretely, we need negative wealth effects, which can come only from tighter fiscal policy, since monetary policy generates positive effects for bond holders.
The issue is that conventional monetary policy analysis, which underlies the Fed’s views, carries an implicit assumption that fiscal contraction consistently follows monetary contraction. This kind of policy coordination looks difficult to achieve in the current policy environment, which takes tax hikes and spending cuts off the table. Yet the assumption is there, and it is essential to the conclusion that inflation falls when the Fed raises the interest rates.
Where does this leave us?
Going back to Andrew’s and Evans’s articles. The federal debt is high and rising. Also, the Fed and the Treasury have chosen to fund the debt by rolling over short-term bonds, as mentioned above. Interest payments are rising. How much? According to the Bureau of Economic Analysis, nominal net interests went from roughly $550 billion in the first quarter of 2019 to almost $900 billion in the second quarter of 2023. If those rising interest payments are paid with more borrowing as opposed to fiscal adjustment (to increase primary surplus), it will fuel inflation.
In other words, when you take under consideration the fiscal and monetary interaction and inflation, you soon realize that there is no other option than D.C. enacting difficult changes.