Why the Fed Will Not Likely Let Rates Go Up (Much More)

The Congressional Budget Office (CBO) updates the 10-year budget forecast each month. The current $1.9T COVID relief Bill has not been signed into law yet, so it is not in these numbers, but it will make the debt/deficit numbers worse. We expect the Biden Administration to put forward a 10-year green infrastructure jobs act in the $3-5T range in Q3. That is not in the numbers either.

2021 2025 2031
Individual income taxes 1,699 2,228 3,096
Payroll taxes 1,325 1,558 1,914
Corporate income taxes 164 355 393
Other 318 365 367
____ ____ ____
Total 3,506 4,507 5,771
Mandatory 3,793 3,618 4,988
Discretionary 1,668 1,620 1,867
Net Interest 303 306 799
____ ____ ____
Total 5,764 5,544 7,654
Deficit (-) or Surplus -2,258 -1,037 -1,883
Debt Held by the Public 22,461 26,559 35,304
Gross Domestic Product 21,951 26,249 32,933
% of Interest Cost to GDP 1.38% 1.17% 2.43%
Estimated cost of debt 1.50% 1.30% 2.4%


There are more than a few alarming trends.

  1. Mandatory spending is largely social benefits and interest cost. Healthcare, social security and the cost of the debt. The cost, as society ages and debt increases, is going to rise considerably as a percentage of the overall budget. In 2022 it is projected to be 86% of tax revenue. By 2025 it will be 87% of tax revenue and 10 years from now 100% of every dollar in tax revenue will go to pay interest costs and social benefits. That’s if there are no hiccups (recessions) along the way. Before COVID, it was projected to be 100% by 2035. This means no Federal employee gets paid a salary unless the money is borrowed. It significantly cuts down the ability of the government to delivery value added services.
  2. Interest costs as a percentage of GDP today is only 1.38% of the GDP. That will rise to 2.43% of GDP by 2031. The CBO projects average interest costs to be 2.4% by 2031 compared to 1.5%. Rates are not going to normalize.
  3. We will see deficits in the 3-5% of GDP range and rising as far out as you want to look.

On the revenue side, individuals pay the lion’s share of taxes. Tax rates will be going up to offset the deficits. Raising corporate tax would help, but it’s too small. If the world embraces the modern monetary theory model of printing money to pay for the excess spending (sadly this is where we are heading), then control of the money supply with be a permanent QE model. Yes, debt monetization, jubilee or whatever you want to call it. A government bond issued with zero interest is fiat CASH.

We see no choice that the Federal reserve has but to keep QE going at the tune of at least $1T per year, and if bond yields do sense inflation, they will need to affect a degree of yield curve control. The mechanics are complicated, but the message is that low rates will be needed so that the cost of paying the interest cost of the debt is not a growing burden on the tax base. And perhaps more importantly, asset markets (read financial conditions in Fedspeak) are stable. We will hear about, and the markets will react to, the idea of tapering asset purchases and higher yields like we are experiencing now. But like every other time (for decades), the Fed will need to step on the gas at some point or risk a meltdown in risk assets that are inflated by those same low rates. Welcome to the moral hazard economy—it’s not going away.

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