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What I Care About This Week | 2021 Dec 20

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by Franklin J. Parker

The Summary

The Details & Charts of the Week

With government spending, inflation, and the role of the Federal Reserve in the news, I thought it timely to take a closer look at interest rates and government debt, and what we can consider sustainable and unsustainable.

Of course, government debt is at an all-time high (first chart below). Though, government debt is always at an all-time high, so this is not a new situation. It has expanded considerably, of course, but what is of more pressing concern is the second chart, which shows the percentage of the federal budget spend on paying for that debt. We have been able to sustain considerably more debt than “normal” because of the third chart: the effective interest rate on government debt at an all-time low.

The ongoing debate, then, is over the third chart. What is sustainable when effective interest rates are less than 2% becomes less sustainable if those rates move to, say, 4%. Based on current debt figures ($28 trillion), a 4% effective rate of interest would force the US Treasury to spend $1.1 trillion per year on just interest payments. To put that into perspective: in 2019 total federal government expenditure was $4.7 trillion.

In other words, if effective interest rates move back to where they were in the early 2000s (not that long ago!), the US government would be spending about 23% of her annual budget on interest payments—more than double what was paid in the 1980s when interest rates were almost 4x higher.

And this is just assuming a return to a long-term average. If the Fed gets aggressive at fighting inflation and effective rates go to 8%, fully half of the federal budget will be consumed with interest payments. That is about the annual military budget of the United States. That appears unsustainable.

All of this matters because it affects how the Federal Reserve can respond to the threat of inflation. Aggressive interest rate hikes are, in reality, off the table. Some other mechanism will have to be used to pull excess cash out of the economy, though exactly what is an open question.

Investors, as I have said many times before, would do well to remain flexible and closely monitor the tug-of-war between policy, inflation, economic growth, and covid. And the sustainability of government spending will affect all of these.

Total Federal Debt.
Percent of Federal Budget Spent on Debt Service.
Effective Interest Rate on Federal Debt.

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