Weekly View: Putting Fed Rate Hikes into Perspective

SUMMARY

• We believe the median forecast for interest rates for the Federal Open Market Committee in 2024 is 2.125%.
• In this event, US Public debt would ultimately increase by 0.8% of Gross Domestic Product by our estimates.
• This increased interest cost should have limited repercussions on the economy and market, in our view.

Over the last couple of months, the mindset of the Federal Open Market Committee (FOMC) has shifted from thinking that inflation was transitory to it becoming a persistent problem. This shift in mindset has unnerved markets. To combat the rapid rise of inflation, the Federal Reserve (Fed) moved to end bond purchases by the end of March. Furthermore, FOMC members have voiced their preference to start hiking the fed funds rate sooner rather than later. The median FOMC member’s projection for the Fed Funds rate for 2024 was 2.125%, as of December 15, 2021, as shown in the chart below. The median projection would imply that the Fed will raise rates eight times over the next 2 years in its quest to fight rising inflation.

Many Americans wonder if a Fed funds rate of 2.125% is manageable given the US Treasury had $29.6 trillion of public debt outstanding as of December 31^st. While the amount is astonishingly high, it is best understood in the context of the US’s $23 trillion economy. We have concluded that the Fed could take interest rates up to its median projection without dramatically upsetting the Treasury’s finances. We will illustrate this by explaining the composition of the $29.6 trillion of public debt outstanding.

Marketable Debt

The marketable public debt consists of Treasury-bills (T-bills), notes, bonds, Treasury Inflation-Protected Securities (TIPS), and Floating Rate Notes (FRN). Currently, marketable securities (those issued and sold through the bond market) make up $22.6 trillion of the outstanding public debt (see chart, below) and carries an average interest rate 1.43%. According to Bloomberg, $6.9 trillion of this debt will be maturing by the end of 2024, accounting for 30% of all marketable public debt. If we were to assume that the average interest rate moved in lockstep with the Fed funds rate, the rate would jump by 2% if the median projection is achieved. This would mean if all the debt maturing between now and the end of 2024 were to be reissued at an average interest rate of 3.43%, it would add approximately an additional $138 billion to the annual interest expense.

Nonmarketable Debt

Nonmarketable debt consists of Treasury securities that are issued directly to government investment accounts, state and local governments tax exempt debt issuers, and other entities within the government for investment and regulatory purposes. Nonmarketable securities make up approximately $7 trillion of the public debt and carry an average interest rate of 2.03%. We could not find the same transparency regarding the maturities of the nonmarketable debt that we found on the marketable debt, so we must make some adjustments to finish the analysis. However, if we were to use the same assumptions that we used for marketable debt, where the average interest rate rose by 2%, in line with the Fed funds rate, and 30% of the debt were refinanced by the end of 2024, there would be an additional $42 billion of annual interest expense.

Public Debt Conclusion

While it is not ideal to add an additional $180 billion to the outstanding public debt due to the Fed attempting to normalize interest rates and fight inflation, we think the additional expense remains manageable when viewed through the lens of Gross Domestic Product (GDP). As mentioned above, US GDP is currently around $23 trillion according to the St. Louis Fed. In this context a $180 billion increase would amount to 0.8% of GDP – a large sum, but manageable in our opinion. One of the Fed’s jobs is to create price stability through managing inflation. With headline inflation at a 39-year high, the Fed is attempting to curtail inflation; and if successful, rates should come down and the US Treasury will have another opportunity to refinance the debt. RiverFront has prepared for rising interest rates by holding an underweight to fixed income relative to our composite benchmarks. We will likely look for more opportunistic levels to re-enter the asset class given that the Fed has plenty of room to raise rates before it becomes punitive for economic growth and financial stability.