The Federal Reserve Open Market Committee (FOMC) of the Federal Reserve (Fed) met Dec. 13-14 and voted unanimously to increase the Fed Funds Rate by 0.25% as anticipated by the markets and discussed in the most recent edition of INTERESTing Times. The committee cited moderately rising household spending, weak business investment, and steady job growth as the primary drivers of the current economic conditions. Because the rate increase was highly anticipated by the markets, the impact was minimal. New York prime rate immediately increased to 3.75%, effective Dec. 15.
Other actions by the Fed that didn’t receive much publicity, include the decision to continue reinvesting maturing Treasury securities, agency debt, and agency mortgage-backed securities. An ongoing buyer in the bond market, the Fed is continuing to be accommodative with its monetary policy.
The next meeting of the Fed is Jan. 31 – Feb. 1. The futures market currently projects a less than 5% chance of a rate hike at this meeting, although it predicts a 40% chance of another 0.25% rate hike at the March FOMC meeting. The FOMC and the markets will be closely monitoring the economic and political developments over the next several weeks in anticipation of the upcoming Fed meetings.
Updated Economic Projections by Federal Reserve Board Members
At the December meeting, each of the 12 Federal Reserve Banks submitted their updated projections of economic activity (i.e., gross domestic product (GDP), unemployment rate, personal consumption expenditure inflation), and, based on these projections, the appropriate Fed Funds Rate. Most of these measures were nudged slightly in an upward direction. Based on these projections, the Fed Funds Rate would increase by 0.80% (roughly three rate increases of 0.25% each) during 2017, and additional increases totaling 0.70% (again, roughly three increases of 0.25% each) during both 2018 and 2019. The long-run Fed Funds Rate is projected at 3.00%. While the Fed has been predicting similar rate increases “next year” for several years now, it had previously not materialized due to weak economic growth. However, the futures market is now taking these predictions more seriously than in the past.To summarize the economic projections, the Fed sees long-term GDP growth of 1.8-2.0%, inflation at 2.0%, and the Fed Funds Rate at 3.00%. As with any projection, the actual outcome will be different, we just don’t know in which way and by how much.
To summarize the economic projections, the Fed sees long-term GDP growth of 1.8-2.0%, inflation at 2.0%, and the Fed Funds Rate at 3.00%. As with any projection, the actual outcome will be different, we just don’t know in which way and by how much.
Global Interest Rates on the Rise
The most recent edition of INTERESTing Times delved into the issue of global interest rates, noting interest rates on sovereign debt worldwide continued to increase alongside the rates in the United States. The interconnectedness of the global financial system continues to remind us that the United States is still the largest economy in the world, and global growth remains heavily dependent on it. Without economic growth at home., the rest of the world struggles. If the U.S. economy can get back on track with an average growth rate, the other economies of the world will also recover. However, stronger economies will lead to higher interest rates as the central banks of the world will likely then reduce the vast accommodative monetary stimulus that has become the rule over the past decade.
Federal Debt Levels and Its Impact on Interest Rates
The United States Treasury ended 2016 with nearly $20 trillion in debt, with approximately $14 trillion of the debt held by the public, and $6 trillion held by intragovernmental holdings (primarily Social Security trust funds). The average interest rate on the entire federal debt at year-end was 2.204%, so the annualized interest cost is approximately $408 billion. Ten years ago, the federal debt was approximately $8.5 trillion with an average interest rate of 5.04%, so the annualized interest cost was approximately $430 billion.
While the total federal debt has more than doubled in the past 10 years, the interest cost is lower today than it was 10 years ago due to the dramatic decline in interest rates. If rates today were at the same level as they were in 2006, the interest cost would be more than $1 trillion, and the budget deficit would be more than double what is reported today (projected at $590 billion for fiscal year 2017).
The sustainability of growing federal debt levels is an increasing concern, but the harmful impact has been masked by the dramatic decline in interest rates. Will soaring federal debt levels lead to higher interest rates and crowd out private borrowing and investments in the future?
Or, will continued low interest rates from the hangover of debt-fueled government spending, slow the country’s long-term growth potential due to the necessary diversion of resources to service the debt? We do indeed live in INTERESTing Times!
Or, will the hangover of debt-fueled government spending result in subpar economic growth and continued low interest rates, since more of the country’s resources will be used to service the debt instead of being more productively spent to expand the economy? We do indeed live in INTERESTing Times!