By Jamie McGeever
ORLANDO, Florida (Reuters) – Much of the debate around U.S. public finances centers on the assumption that structurally higher interest rates will push debt servicing costs to intolerable levels, risking a fiscal catastrophe that can only be averted through severe austerity.
While borrowing costs and spending are justifiable sources of angst, this ignores the other side of the government’s ledger. What if interest rates and bond yields stay ‘higher for longer’ partly because the economy is ‘stronger for longer’?
More vibrant growth boosts tax revenue, but this often gets lost in the noise surrounding the trajectory for spending.
In its February forecasts the non-partisan Congressional Budget Office sketched out some pretty sobering figures. But it also estimated that the workforce will increase by 5.2 million people over the 2023-2034 period, mostly due to higher net immigration, which will boost economic output by $7 trillion and tax revenues by $1 trillion.
“Higher immigration could help boost GDP growth on a sustained basis, and this would help stabilize the debt-to-GDP ratio,” said Marc Giannoni, chief U.S. economist at Barclays.
In a $28 trillion economy, the compound effect on tax revenues of annual economic or productivity growth exceeding consensus projections by one or two tenths of a percentage point can be significant.
An interactive table on the CBO’s website, based on its long-term projections from early last year, shows just how significant.
All else equal, a 0.2 percentage point increase in productivity every year in the 2024-2033 decade would increase revenues by $673 billion and reduce the deficit by $400 billion, relative to the CBO’s baseline projections.
The economy would be almost $1 trillion larger at the end of the decade at $40.5 trillion, and the debt-to-GDP ratio would be 3.4 percentage points lower at 114.8%, again relative to original baseline projections.
BOND MARKET NOT SPOOKED
Economists note the importance to debt sustainability of the relationship between debt servicing interest costs and economic growth rates – also known as ‘r minus g.’
The CBO’s baseline projections are for annual nominal GDP growth and the 10-year Treasury yield to both average around 4% over most of the coming decade.
The average interest rate being paid on the $34 trillion of outstanding U.S. public debt is rising, and has just gone above 3%. However, that is still historically low, and well below recent and current nominal GDP growth rates of over 5%.
Despite a rising term premium, huge debt issuance, and expectations that the Fed could soon raise ‘R-star,’ its estimate of the long-term neutral rate of interest, U.S. bond yields are lower than they were in October.
Since the Fed first raised rates two years ago, Treasury market volatility has rarely been lower – partly because inflation has cooled and is now near target, but probably also in part due to a ‘stronger for longer’ economy.
Stronger long-term growth may be needed to keep a lid on the deficit and debt, absent large tax hikes or major changes to mandatory spending programs like Social Security.
“This leaves the rate of economic growth relative to interest rates as the crucial factor determining the path of the debt-to-GDP ratio over the next few decades,” researchers at the San Francisco Fed wrote in February.
“New technological advances, such as artificial intelligence, could fuel a productivity-led boost to long-run economic growth” they added.
THE ‘RIGHT’ KIND OF GROWTH
On a basic level, debt sustainability relies on the nominal rate of GDP growth exceeding the nominal rate of interest paid to service the federal debt, or the real GDP growth rate exceeding real borrowing costs.
The primary budget balance, which excludes interest payments, is also a key measure.
The CBO recently published its latest long-term projections and it’s not hard to see why some of the numbers are cause for concern – persistently wide deficits, record interest payments as a share of GDP, and a steady increase in the debt-to-GDP ratio are all on the horizon.
Billionaire hedge fund manager Geoffrey Gundlach warned recently that interest rates of 6% over the next five years would mean “50% of tax receipts would have to go to interest expense … which is completely possible.”
The Fed policy rates doesn’t directly influence long-term Treasury yields, but interest payments only appear to be going in one direction. Can growth help offset it, and more importantly, will it be the right kind of growth fueled by productivity gains or higher immigration?
“If nominal GDP is accelerating because real growth is growing, that’s a really good situation, but if it’s inflation is going up, you’re shooting yourself in the foot,” said Joe Kalish, chief global macro strategist at Ned Davis Research.
(The opinions expressed here are those of the author, a columnist for Reuters.)
(By Jamie McGeever; Editing by Andrea Ricci)
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