Mind on Money: Economic math getting more complicated

Mind on Money: Economic math getting more complicated

This week, as expected, the Federal Reserve bank raised short term interest rates by one quarter of one percent. As we have discussed often before, this policy change was focused on reducing price inflation in our economy. The policy change was the eighth interest rate increase in the current cycle, and takes the Fed’s benchmark interest rate from 4.5% to 4.75%. Just nine months ago, this rate was substantially at zero percent.

These rate increases are going to hurt us on house payments, on car loans, on credit card rates and dozens of other credit products, and higher interest rates typically take stock prices lower, and even after a couple of strong months, major stock indexes remain about 15% off their highest levels from late 2021. I have no doubt all of this will slow the economy down some, as most us will feel, and be, less wealthy. Being less wealthy should lead us to spend less and walla, less spending should be mean less inflation. Irritating but endurable, as most of us have been through this before.

For the government, however, these rates increases have the potential to be much more impactful. As I write this column the U.S. federal government owes $31.45 trillion (source: fiscaldata.treasury.gov). While this number is absurdly huge, this is not theoretical money. This debt is comprised of very real money and is owed in the form of bonds owned by very real banks and investors. These bonds pay interest like any other bonds, and for the past 14 years the government has been issuing bonds at very low interest rates, and sometimes at practically no interest rate at all. The benefit of interest rates being low for so long is in 2022 the average interest rate on all U.S. government bonds was only 2.07% (source: fiscaldata.treasury.gov). $31 trillion at 2%, what a deal. Unfortunately, this deal is about to come to an end.

It's important to understand, the whole $31 trillion national debt is not subjected to interest rate increases all at once. The bonds comprising the national debt are maturing constantly and being reissued constantly. On average, however, about 30% of the debt will mature and need to be reissued in one to three years. This means around $10 trillion which was borrowed at 0% to 2% will likely be reissued at around 4% in the near future. To make the math easy, let’s say this will lead to increased interest payments alone of $200 billion a year in just the next few years, and it only get worse from there.

Under the current tax regime federal tax receipts have been coming in at record levels. In 2022 the federal government took in almost $4.2 trillion, which means just the interest rate increase alone has the capacity to suck up nearly 5% of federal revenue. It's easy to see where I’m going with this; this is indeed a serious math problem.

There are a couple of countermeasures the government can use to address this math problem, all of which present a form of fatal alternative. The Fed can lower interest rates, but with inflation burning hot, this option is dangerous as inflation is the enemy of societal stability. The government can attempt to change tax rates, but even those on the left now understand that higher rates don’t equal higher tax revenue, as a growing economy creates the most tax revenue, and tax hikes tend to slow growth. Of course, the government can shrink its spending, but with 60% of federal spending attributed to Social Security and Medicare/Medicaid, 11% going to military defense and 4% already going to interest payments on the debt (source: OMB), this means the government would be trying to squeeze savings out of only the remaining 25%. Good luck with that, and for the first time in years, the government can’t just gorge on more borrowing, because we’ve finally arrived at that point where this just makes the problem worse right now.

So as the partisan rhetoric heats up with talks of a national sales tax, Social Security reform and very soon the debt ceiling, it's going to be important to look past the propaganda and try to truly understand the math. I believe the long cycle of ever-growing government is approaching an end, and what this ends up looking like on the other side may be quite different from what we’ve known in the past.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Stock investing includes risks, including fluctuating prices and loss of principal. No investment strategy can guarantee a profit or preserve against loss. Past performance is not a guarantee of future results. This material may contain forward looking statements; there are no guarantees that these outcomes will come to pass.

Marc Ruiz is a wealth advisor and partner with Oak Partners and registered representative of LPL Financial. Contact Marc at marc.ruiz@oakpartners.com. Securities offered through LPL Financial, member FINRA/SIPC.