Why everyone should care about rising interest rates

In the rarefied world of the Federal Reserve, the actions by the mandarins of fiscal policy can be based on obscure and secret economic data.  So we don't really know why Chairman Yellen switched gears and raised interest rates for the first time since 2007.  She promises a gradual rise in interest rates with a target of 1.5% by the middle of 2017.

The economy, the Fed says, is gradually improving.  I would add to that "in some places."  This "recovery" is the weakest in history, and the real jobs numbers – when you add in those too discouraged to look for work and part timers who want full-time jobs – haven't budged much since 2011.

Profits are up, as is the stock market.  But the burden of gradually rising interest rates on the private sector is only half the story.  The real issue is that rising interest rates – even if done gradually – mean a big increase in servicing the debt.

In fact, the CBO has estimated that by 2025, 800 billion of our tax dollars every year will be going to service our massive public debt.  Here's what that means in practical terms for our national defense, and all non-defense discretionary spending.

From a Wall Street Journal article early this year:

Currently, the government’s interest costs are around $200 billion a year, a sum that’s low due to the era of low interest rates. Forecasters at the White House and Congressional Budget Office believe interest rates will gradually rise, and when that happens, the interest costs of the U.S. government are set to soar, from just over $200 billion to nearly $800 billion a year by decade’s end.

By 2021, the government will be spending more on interest than on all national defense. according to White House forecasts. And one year later, interest costs will exceed nondefense discretionary spending–essentially every other domestic and international government program funded annually through congressional appropriations. (The largest part of the budget is, and will remain, the mandatory spending programs of Social Security, Medicare and Medicaid. Mandatory spending is over $2 trillion and is set to double to $4 trillion by 2025.)

The total dollars spent on defense and nondefense discretionary spending will continue to rise, albeit slowly, in the coming decade. But as a share of the economy, both categories of spending are poised to shrink for the next decade, squeezed down as interest rates rise. Mandatory spending will rise from 12.4% of GDP to about 14.5% of GDP over this period.

By 2025, the White House projects interest costs will be 2.8% of GDP. The CBO is somewhat less optimistic and expects it will be 3%. Most economists and budget experts would agree that interest payments at 3% of GDP are manageable for an economy. The true cost may be the squeeze to other places the government could be spending a decade from now.

Suppose we have a touch of inflation over the next few years.  That $800 billion a year in debt service may seem a dream.  Historically, interest rates have hovered around 5%.  Debt service costs on interest rates at that level would be $900 billion a year.

Even the CBO's more realistic numbers don't tell the whole tale.  The federal budget deficit is ramping up after a few years in decline and will reach a trillion dollars a year again by 2020.  And by 2025, the national debt is projected to be more than $27 trillion.

"Unsustainable" is a word thrown around a lot by policy makers that doesn't seem to cause any great concern on Capitol Hill.  But these numbers threaten everything you've worked for and tried to build for yourself and your family.  Quite simply, we can't keep going like this.  This would appear obvious to even the most oblivious among us.  But Congress and the president can't find the courage to do what has to be done now to avoid the train wreck.  Medicare, Medicaid, Social Security, and debt servicing are already off the tracks and out of control.  Unless drastic, unprecedented action is taken, we'll all join them shortly.

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