Interest costs on the national debt aren’t likely to grow to unsustainable levels in the next decade even if the Federal Reserve begins to raise rates later this year, according to Bank of America Merrill Lynch.
The bank said the combination of an improving economy that helps to narrow the budget deficit and a sustained period of low rates will prevent the US from entering an unsustainable debt trap. The government has managed to shrink budget deficits since the end of the Great Recession in 2009.
“The deficit is no longer a scary 9.8 percent of GDP as in 2009, when collapsing tax revenues, expanding outlays and a temporary stimulus package all boosted the deficit,” said Ethan Harris, head economist at BofA. “More recently, better economic growth and a combination of tax hikes and cuts to discretionary spending have helped bring the deficit/GDP ratio down to nearly 4 percent in 2013 and below 3 percent in 2014.”
The White House this month forecast that interest payments on the country’s $18 trillion in debt will overtake defense spending in 2021 and non-defense the following year. In a separate report, the Congressional Budget Office estimated the national debt will rise from around about 73 percent of gross domestic product in 2018 to nearly 79 percent in 2025.
BofA’s Harris said longer-term trends show no reason for alarm.
“By 2025, net interest costs as a share of GDP should not be any larger than during much of the 1980s and 1990s, even with the CBO’s above-consensus interest rate path,” he said in a February 12 report obtained by MoneyNews. “Markets are currently pricing in much lower rates; if realized, the likely rise in net interest costs would be correspondingly less.”
The US government has locked in low longer-term interest rates while the average maturity of its debt has risen to about 70 months from 50 months since the financial crisis.
“We don’t recommend investors fixate on this issue when there is still plenty of time for politicians to fix it,” BofA said. “Then again, a little worry direct at one’s local Congressional representatives might help prod them into taking actions to shore our long-run fiscal house.”
Art Laffer, a former economic adviser to Ronald Reagan, said the government will be in a crunch when interest rates rise. Investors expect the Federal Reserve to raise rates as early as June.
"I don't think interest rates will stay this low forever," Laffer said on Fox News Channel's "Your World with Neil Cavuto."
All the debt held by the public is short term, and the Federal Reserve owns almost all of the long-term debt, Laffer said.
As soon as interest rates start rising, they will rise as an expense of the federal government and won't have a long-delayed effect, he said.
"So, if rates rise and you have all this debt sitting out there, you're going to have a serious deficit problem just by interest on the national debt alone,” Laffer said.
Obama assumes all of his proposed taxes will produce revenues, and also that all of his taxes will pass Congress with no "supply-side" response, he said.
"But let me just tell you, that's not the way the world works," Laffer told Cavuto. "If you tax people who work and you pay people who don't work, which is what his proposal is, you're going to find a lot of people not working, many more than you expected."
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