For 2016 and beyond, all official U.S. economic forecasts call for stronger growth ahead. But, economic output is not the only variable on the rise. Inflation, debt levels, interest rates, and market valuations are also increasing. What does this mean for investors?
On April 29, 2015, the Federal Reserve released an updated U.S. economic forecast for 2016 and years ahead.
The Fed reaffirmed that the federal funds rate, the benchmark short-term interest rate, is currently in its correct range; 0.0% to 0.25%. That said, what the market continues to grapple with is the reality of higher interest rates ahead. Notably, the Fed stated that it would look at both realized and expected economic data related to employment and inflation.
So, what are the official expectations? The Congressional Budget Office (CBO) estimates that the U.S. economy, after growing 2.1% in 2014, will expand at 2.9% in 2015 and 2016. The majority of the economic growth will be driven by a rise in consumer spending and fixed asset investment by businesses. For example, consumer spending will account for 2.3% of the 2.9% gross domestic product (GDP) growth expected in 2015. (Source:CBO, last accessed May 7, 2015.)
The CBO also forecasts that stronger hiring in the coming years will reduce unemployment from the current 5.5% to about 5.3% by the end of 2017. The Federal Reserve is more optimistic. Current forecasts call for unemployment to be in the range of 4.8% to a high of 5.1% by the end of 2017. Therefore, the headline unemployment number is expected to decrease slightly. (Source: Federal Reserve, April 8, 2015.)
Economists at the CBO also have a forecast for inflation. They expect inflation, as measured by the personal consumption expenditure index, to stay below the Federal Reserve target of two percent until 2017. The latest numbers, from the Bureau of Labor Statistics, show inflation stood at -0.1%; which means prices are declining. (Source: BLS, April 17, 2015.)
A sharp rise in inflation is expected. The absence of an increase will likely push the Federal Reserve’s interest rate decision past the July and September 2015 meetings, which is the current consensus.
Interest Costs and Debt
One thing that isn’t on a positive trajectory is debt. According to the CBO, as of 2014 year-end, public debt stood at $12.8 trillion or 74% of GDP. (Source: CBO, January 26, 2015.)
What is surprising is that despite positive economic forecasts for 2016 and beyond, and rising inflation, U.S. debt levels are not expected to decrease. You would think a better economy would require less borrowing. But, in fact, the opposite is true. The $12.8 trillion of debt, held by the public, is expected to rise to over $21.0 trillion, or 79% of GDP, by 2025.
Not only will debt rise, but so will interest rates.
The interest rate on a three-month Treasury bill currently stands at 0.01%. That’s essentially zero percent—or zero return for the holder. A U.S. Treasury bill with a 10-year maturity currently has an interest rate of 2.12%. (Source: U.S. Treasury, last accessed May 7, 2015.)
The CBO expects interest rates on three-month Treasury bills to average 0.2% in 2015 and rise sharply to 1.2% in 2016. In the long run, that same Treasury bill is expected to average 3.5%. That’s a sharp move up in short-term rates, but is merely a return to normal conditions—an environment the market isn’t used to.
At the long end of the curve, interest rates are expected to increase as well. For example, 10-year Treasury note yields are expected to increase from their current rate of 2.12% to 3.4% by 2016, and over 4.5% in the long run. The last time the bond market saw 10-year notes yield 4.5% was in August 2007 before the financial crisis took hold.
A rise in Treasury interest rates inevitably means an increase in U.S. government borrowing costs. Interest rates on the continuously increasing U.S. public debt will rise. The CBO expects the average interest rate on debt to climb from 1.7% in 2015 to 2.0% in 2016, and to 3.3% by 2020 year-end.
The CBO also highlights that debt levels are at historically high levels. Debt held by the public in 2014 was the highest since 1950. As a percentage of GDP, public debt in 2014 totaled 74%. That’s about twice the average levels experienced in the period between 1965 and 2014.
In fact, as recent as 2007, debt as a percentage of GDP only ran at 35%. However, the Great Recession of 2008 to 2009 had severe consequences on Federal coffers. U.S. economic forecasts for 2016 see U.S. public debt reaching 74% of GDP. Federal obligations and increasing interest expenses will have significant effects on the U.S. economy in 2016 and beyond.
The problem is that interest rates on debt are set to rise. On top of that, given budget assumptions and economic growth forecasts, total U.S. public debt levels are also set to increase. As a result, the federal budget deficit will also widen.
An increase in debt and servicing costs squeezes government finances. National savings will drop, limiting investment into the U.S. economy. Moreover, onerous budget shortfalls will handcuff the Federal government in responding to future crises.
It looks like the U.S. economy is already in a recession, according to these indicators. The Institute of Supply Management’s Manufacturing Purchasing Managers’ Index (PMI) has been below 50 since October of 2015. Any reading on the PMI below 50 suggests a contraction in the manufacturing sector of…
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