Hold short-term interest rates at current levels, and threaten to raise them if inflation morale doesn’t improve. That’s current Federal Reserve policy. The trouble is that the central bank doesn’t set interest rates anymore. The bond market does.
The Fed has increased its short-term policy rate by only 0.25 percentage point since May 3. The interest rate that matters most to households, businesses and governments, however, is set by the 10-year Treasury note. And it’s up nearly 1.5 points since the spring, and up about 0.75 point in the past month. I expect the most significant tightening to the real economy in the cycle to begin around the end of the year.
The U.S. is courting trouble. The federal government is 43% larger than it was four years ago, and its reach is expanding mightily. More than a third of the surge in investment spending can be traced to government subsidies, credits and handouts. The chosen corporate recipients of the government’s largess ostensibly benefit, but the rest of the private economy will be burdened by significantly higher rates and rising costs of doing business.
The coming supply of Treasury securities required to fund U.S. government deficits will likely be substantially larger than official estimates. And purchasers of Treasury debt will demand higher yields, at least until something breaks in the economy.
First, on the supply side. The government currently funds $33 trillion of outstanding debt at an average interest rate of about 2.9%. Funding costs on the growing debt burden are forecast to average only a fraction of a percentage point higher over the next 10 years, according to the Congressional Budget Office. I’ll take the over.
The bond market is signaling heightened uncertainty about the range of possible outcomes. If the Fed’s recent rosy economic forecasts for growth and inflation are wrong and a recession ensues, there will be a gusher of new debt. Every additional 1-point increase in interest rates will add more than $2.5 trillion of expense in the next decade.
Next, on the demand side. After the global financial crisis, four of the largest purchasers of Treasury debt were price-insensitive. That is, they were buying Treasury debt for policy reasons—economic, geopolitical or regulatory. Price didn’t matter. How fortunate. These buyers, however, have largely exited the market. The Fed bought about a quarter of all Treasury debt in the past decade but warns that its Treasury holdings will shrink for at least another year.
China, another massive buyer in recent years, is unlikely to sell its existing holdings at a loss. But don’t expect Chinese leadership to do the U.S. any favors by showing up in size at the next Treasury auction. Japan’s domestic growth profile is the most robust in decades. The lion’s share of its excess savings will stay closer to home. And after the banking debacle in March catalyzed by Silicon Valley Bank, the largest banks—firmly overseen by their regulators—are no longer keen to load up on “risk-free” long-dated Treasury bonds.
Yields on the benchmark bond can rise for good reasons. Maybe markets are expecting a stronger economy and a tame business and financial cycle. Perhaps, with luck, the inflation surge will pass without a trace. Maybe policy makers in the White House and Congress will cut a grand bargain to bring an end to the fiscal folly. Perhaps the U.S. economic engine will overpower the recessionary trends elsewhere in the world. But it would be Pollyannaish to bet the country’s future on any of it.
The U.S. economy has proved particularly resilient in the past year, a testament to its residual dynamism. The bigger story, however, is the insulation of large parts of the economy from the Fed’s increases in short-term rates. About 90% of single-family residences are sitting on fixed-rate mortgages, and more than two-thirds of auto loans are locked in at materially lower rates. On the business side, the overwhelming majority of investment-grade corporate debt is fixed at low rates. All of these loans, and lower-quality companies with weaker credit profiles, are likely to require refinancing in a much tougher macro environment.
Mr. Warsh, a former member of the Federal Reserve Board, is a distinguished visiting fellow at the Hoover Institution.