It is always nice to be right. On May 5th, I predicted that the Federal Reserve would not raise its interest rate in June. I also predicted that the European Central Bank would continue with its rate hikes.
Last week both central banks proved me right, as the Fed kept its federal funds rate unchanged while the ECB raised its three lead interest rates by 0.25%.
Both decisions were good given the macroeconomic contexts in which they were made. The U.S. economy is well past the peak of its inflation, with consumer prices rising at only 4.05% in May. Producer prices fell by just over 7%, which means that consumer-price inflation is being pulled down by producer prices.
In plain English: we can expect inflation to continue to taper off.
The inflation trend in Europe is also positive, but with less clarity. Overall, the euro zone recorded a rate of 6.1% in May, down from 7% in April and 6.9% in March. The rate remains approximately one percentage point higher in the EU as a whole.
Although the trend is pointing downward, the high rates merited another interest rate increase by the ECB. Strictly speaking, their influence stops at the borders of the euro zone, but in practice, they are the benchmark central bank for the whole of Europe. Therefore, policy-wise they are also responsible for the inflation rate in the entire European Union.
With this in mind, the ECB made the right decision by raising the interest rate. This invokes hope that Europe will experience the same lower levels of inflation that Americans now have. However, this requires an overall macroeconomic trend that is fundamentally positive; currently, Europe is more likely to go into a recession than anything else, which puts a cap on how high the ECB will want to go with its interest rates.
I do not see the same risk of a recession in the U.S. economy. That, however, does not mean everyone agrees with me. The Federal Reserve has decided that the U.S. economy is going to virtually stand still through 2025. If I am wrong and they are right, it will have far-reaching consequences for both the United States and the parts of the rest of the world that depend on trade and financial relations with the U.S. economy.
If the Fed’s forecast becomes true, a debt crisis will be at the top of the list of problematic consequences. If Congress does not get to work on major, structural reforms to the federal government’s myriad of spending programs, we can pencil in a debt crisis with near-perfect certainty.
The reason is found in the Monetary Policy Report, which the Federal Reserve publishes on an annual basis. The report is important for many reasons, one being that it places the Fed’s current monetary policy in a broader macroeconomic context.
Another big reason to read it is its presentation of the central bank’s latest outlook on the American economy. This part does not get enough attention, especially since the Federal Reserve has some of the best economic forecasters in the world. The just-released report is of special importance because of its disappointing outlook on the U.S. economy over the next couple of years (p. 47, Table 1).
They predict that gross domestic product, GDP, is only going to grow by an inflation-adjusted 1% this year, by 1.1% next year, and 1.8% in 2025. These numbers are well below the growth rates during the 2010s, which in itself was a disappointing decade. It was during this time, and the preceding decade, that much of the federal government’s current debt problems started to build up.
If we are going to see even lower GDP growth rates, we can safely foresee even larger budget deficits. The reason is to be found in the construction of the federal government’s tax revenue system: in the first quarter of this year, approximately 48% of the federal government’s total revenue came from the personal income tax, while payroll taxes contributed about 38% of the revenue. With $86.60 of every $100 of federal government revenue being levied on personal income, it is easy to see how a slowdown in GDP growth will cause much bigger deficits than what the federal government’s budget is plagued by today.
Personal income equals 85% of GDP. This means that over time, the long-term growth rate of federal tax revenue will match that of GDP through personal income.
Given the poor GDP growth numbers above, this is nothing short of macroeconomic dynamite. To see just how explosive the numbers are, we need to identify the expected growth rate in federal tax revenue. We do that by adding inflation to the aforementioned GDP growth numbers for 2023-2025. The reason why we do this is that the government budget operates in a world where inflation exists; put differently, we all pay our taxes with inflation-adjusted dollars, and we get government benefits by means of inflation-adjusted dollars.
The Fed’s Monetary Policy Report predicts that consumer-price inflation will be 3.9% for 2023, 2.6% for 2024, and 2.2% for 2025. If we add these numbers to the real growth rates, we get 4.9% for 2023, 3.7% for 2024, and 4.0% for 2025.
With these numbers in mind, let us look at Table 1, which reports the 10-year average growth rates for federal spending and tax revenue:
Table 1
Source of raw data: Bureau of Economic Analysis
Starting in the 1960s, federal spending has outgrown federal tax revenue every decade except the 1990s. Since at least the 1950s, the federal government has grown its spending by more than 7% per year, on average. With no structural spending reforms in sight, it is fair to assume that this is the rate at which spending will continue to grow for the foreseeable future. Using the 7.3% annual average since the turn of the Millennium, we can now compare the expected growth rate in spending and revenue for the three years included in the Federal Reserve’s Monetary Policy Report.
The revenue growth rates of 4.9%, 3.7%, and 4.0% for 2023-2025 put revenue far behind spending. While many details are uncertain, it is fair to say that we could see a total of $800 billion to $1 trillion in accumulated extra deficits for these three years. In other words, this is what we have to add to the three years’ worth of budget deficits that the White House’s Office of Management and Budget, OMB predicts for 2023-2025 (see Table 1.1). These deficits are expected to be $1.5-$1.6 trillion per year, or approximately $4.6 trillion for the three years in question.
If we add the extra deficits that result from a decline in revenue, we are at a total of $4.4-4.6 trillion for the three years.
This is not sustainable. The market for federal debt is already having trouble absorbing the current levels of government borrowing. These difficulties are visible in the high yields paid at both the auctions and secondary markets for U.S. debt. As of June 16th, Treasury bills—which mature in one year or less—paid 5.18-5.38%; the lowest yield was on the 10-year Treasury note, which paid 3.77%.
It has been ten years since any maturity of U.S. government debt paid these rates.
In fairness, today’s high interest rates are not solely the work of withering confidence in the U.S. government’s ability to honor its debt commitments over time. Those concerns are a new addition to the market and started making themselves visible only recently, when there was no major drop in interest rates as a result of the deal between President Biden and Congress on the U.S. debt ceiling.
The main driving force behind the current rates is instead the Federal Reserve, which started tightening its monetary policy over the past year. Two years ago, the federal funds rate—the rate by which the Federal Reserve ‘sets’ its monetary policy—was 0.06%. A year ago, it had increased to 0.83%; as of June 16th, 2023, the federal funds rate was 5.07%.
Naturally, these policy-setting rate hikes will drive the market rates upward. However, the market can also drive a central bank ahead of itself: when investors grow weary of the solvency of a government and therefore start selling its debt securities, the central bank has no choice but to raise its rates in order to regain command of its own monetary policy.
So far, the Federal Reserve has not been put on the defensive by the market. Unlike some central banks in Europe, including the ECB, the Fed has stayed ahead of the market and therefore been able to use its monetary policy to bring down inflation. Its policy command even allowed it to not raise the federal funds rate at last week’s meeting with its policy-making outfit, the Federal Open Market Committee (FOMC).
However, the Fed is walking a thin line here, by no fault of its own. Congress is pressuring the market for U.S. government debt by merrily planning on borrowing massive amounts of money in the coming years. According to the aforementioned OMB numbers, the total deficits from 2023 through 2028 amount to $9.7 trillion. This is the extra amount of money that Congress is going to have to borrow, should they choose not to address their spendaholism.
According to a debt analysis model that I have developed, the current average interest rate on the U.S. debt is 2.56%. If this rate applies to the debt from today through 2028, the annual cost of the debt to Congress—in other words the money they have to ask taxpayers for every year—will increase from $839 billion this year to $1.05 trillion in 2028. However, if we
a) make the very realistic assumption that interest rates will gradually rise until they reach 5% by 2028, and
b) add 20% to the debt as a result of slow GDP growth,
then the trajectory of the debt cost suddenly looks very different. Reaching $901.6 billion this year, it eclipses $2 trillion by 2028. The federal government’s outlays for interest on its debt now rise by 26% in 2024, 19% in 2026, and 10% in 2028.
These are astounding numbers that are not far from becoming reality. If they do, they would force the federal government to increase its budget by as much as 16% (compared to the current OMB spending forecast) just to accommodate the rising debt cost.
This is enough to destabilize the sovereign-debt market and set a U.S. debt crisis in motion. The consequences are almost unforeseeable, at least within the realm of realistic forecasting. That makes it all the more important for us to take the warning signs with all the seriousness they merit.
