What a Difference a Couple of Points Can Make

The Bank of England was the first of the major central banks to raise interest rates. As we know, the U.S. Federal Reserve followed suit. Rates are also rising in countries like Canada. In general, central banks around the globe are raising interest rates.

This could be perceived as good news because the confidence central bankers display in raising rates sends a layman’s message that economies are improving. However, higher rates have a severe, negative impact on people, companies, and institutions that are heavily in debt.

Japan is a case in point. Japan is the second largest economy in the world after the U.S. Right through the three recessions the country encountered since 1991, the Japanese government decided to spend “like crazy” to get its economy going. Japan’s federal government debt is now 145% of gross domestic product.

Japan’s debt is the largest in the industrialized world. And higher interest rates will make that debt more difficult to manage. It’s no wonder Moody’s has cut Japan’s debt rating six times since 1988 to the lowest among the Group of Seven industrialized countries.

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The yield on a Japanese 10-year government bond is now about 1.95%, the highest level in four years and up almost 1.5% since the 10-year government bond’s record yield low set in June 2003. If rates rise only slightly more in Japan, the country will be facing another crisis, as it craters under its huge debt burden.

A rate hike of one percentage point didn’t mean much back in the 1980s or 1990s. Remember when borrowing rates were above 15% in the early 1980s? A one-percentage-point move did not make much of a difference to the economy at all.

But today, with the onslaught of auto loans, credit cards, personal credit lines, home equity lines, and jumbo mortgages, a one percentage point change in interest rates does makes a big difference. And that’s because consumers are heavily in debt. In fact, the debt-to-income ratio of consumers has consistently been at record highs over the past couple of years.

And government is no different. When times are economically difficult, governments spend to spur economic growth. We’re facing a record U.S. government deficit this year of about half- a-trillion dollars. If the U.S. Federal Government’s cost of borrowed funds goes to 5%, we’re looking at $25 billion just to service this year’s deficit!

Don’t let anyone fool you. If the Federal Reserve makes good on its promise to continue its “measured” interest rate increases, the higher rates, even though minor in numeric figures, will have a profound, negative effect on consumer and government debt burdens.