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One reason why the Fed can’t raise rates

27082019_interest rates

One reason why the Fed can’t raise rates

A lot is being written about the low interest rate environment in which we find ourselves. And rightly so: we would rank this as the number one most powerful force affecting asset prices today.

As for the reasons behind the interest rate dynamics we are seeing, there are many – including those related to demographics, technology and globalization. But there is another really simply reason why interest rates can’t increase on a sustained basis: indebtedness.

Take the United States, for example. At around 100 per cent government debt to GDP, this means that for every one per cent increase in interest rates, this equates over time to increased interest expense that needs to be funded by the annual budget – to the tune of one per cent of GDP. Said another way, this is akin to one per cent of negative fiscal stimulus.

The chart below was recently published by the Congressional Budget Office. It shows the annual budget of the US federal government, expressed as a percentage of GDP. The pink bars show the primary surplus/(deficit) which is the budget balance before the effect of interest. The green bars then show the net interest component – which, despite the low interest rate environment, is becoming more negative. Why? Because of the increased government borrowings required to fund the recent Trump tax cuts.

Screen Shot 2019-08-26 at 11.26.48 am


Should interest rates rise, the green bars would become significantly more negative – and the government may be forced to offset these with more positive pink bars. How do you make the pink bars positive? You raise taxes or cut government spending – both of which would damage growth and therefore push interest rates back down. Through this lens, the more that governments borrow, the more certain we can be that interest rates won’t rise.


Andrew Macken is the Chief Investment Officer of the Montaka funds and the Montgomery Global funds. He established MGIM in 2015 in partnership with Montgomery.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.

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  1. It’s obvious rates can’t be raised, they will be lowered if anything, and deeply negative. Whats not so obvious is the unknown outcomes of doing so.
    I agree with Ray Dalio when he says gold will likely outperform most other assets in the coming years,
    This is a big statement coming from the bond king, Is he is calling the top of the bond bubble ? and if so the consequences of that are significant to say the least.

      • Roger there is so much evidence to back up that call it’s ridiculous now, if you can’t see the massive bond bubble, the biggest bubble in the history of everything imo, or the yield curve inversion, or the spike in gold and silver, which is paying nicely I might add, I don’t know Roger need I go on?
        Even mainstream financial commentators are calling recession now the drum is deafening.
        But maybe I’m wrong, my PM account says I’m right.

  2. “You raise taxes or cut government spending – both of which would damage growth”

    A Fiscal History Lesson by David R. Henderson
    “The final conclusion to be drawn from our experience at the end of the last war is inescapable—were the war to end suddenly within the next 6 months, were we again planning to wind up our war effort in the greatest haste, to demobilize our armed forces, to liquidate price controls, to shift from astronomical deficits to even the large deficits of the thirties—then there would be ushered in the greatest period of unemployment and industrial dislocation which any economy has ever faced.”
    —Paul Samuelson, 1943

    “[A]t the end of 1946, less than a year and a half after V-J day, more than 10 million demobilized veterans and other millions of wartime workers have found employment in the swiftest and most gigantic change-over that any nation has ever made from war to peace.”
    —Harry S. Truman, January 1947

    In a 2010 study for the Mercatus Center at George Mason University, I examined the four years from 1944, the peak of World War II spending, to 1948. Over those years, the U.S. government cut spending from a high of 44 percent of gross national product (GNP) in 1944 to only 8.9 percent in 1948, a drop of over 35 percentage points of GNP. The result was an astonishing boom. The unemployment rate, which was artificially low at the end of the war because many millions of workers had been drafted into the U.S. armed services, did increase. But between 1945 and 1948, it reached its peak at only 3.9 percent in 1946. From September 1945 to December 1948, the average unemployment rate was 3.5 percent.


    Historically minded readers may be saying, “There was a Depression in 1946? I never heard about that.” You never heard of it because it never happened. However, the “Depression of 1946” may be one of the most widely predicted events that never happened in American history. As the war was winding down, leading Keynesian economists of the day argued, as Alvin Hansen did, that “the government cannot just disband the Army, close down munitions factories, stop building ships, and remove all economic controls.” After all, the belief was that the only thing that finally ended the Great Depression of the 1930s was the dramatic increase in government involvement in the economy. In fact, Hansen’s advice went unheeded. Government canceled war contracts, and its spending fell from $84 billion in 1945 to under $30 billion in 1946. By 1947, the government was paying back its massive wartime debts by running a budget surplus of close to 6 percent of GDP. The military released around 10 million Americans back into civilian life. Most economic controls were lifted, and all were gone less than a year after V-J Day. In short, the economy underwent what the historian Jack Stokes Ballard refers to as the “shock of peace.” From the economy’s perspective, it was the “shock of de-stimulus.”
    If the wartime government stimulus had ended the Great Depression, its winding down would certainly lead to its return. At least that was the consensus of almost every economic forecaster, government and private. In August 1945, the Office of War Mobilization and Reconversion forecast that 8 million would be unemployed by the spring of 1946, which would have amounted to a 12 percent unemployment rate. In September 1945, Business Week predicted unemployment would peak at 9 million, or around 14 percent. And these were the optimistic predictions. Leo Cherne of the Research Institute of America and Boris Shishkin, an economist for the American Federation of Labor, forecast 19 and 20 million unemployed respectively — rates that would have been in excess of 35 percent!
    What happened? Labor markets adjusted quickly and efficiently once they were finally unfettered — neither the Hoover nor the Roosevelt administration gave labor markets a chance to adjust to economic shocks during the 1930s when dramatic labor market interventions (e.g., the National Industrial Recovery Act, the National Labor Relations Act, the Fair Labor Standards Act, among others) were pursued. Most economists today acknowledge that these interventionist polices extended the length and depth of the Great Depression. After the Second World War, unemployment rates, artificially low because of wartime conscription, rose a bit, but remained under 4.5 percent in the first three postwar years — below the long-run average rate of unemployment during the 20th century. Some workers voluntarily withdrew from the labor force, choosing to go to school or return to prewar duties as housewives.
    But, more importantly to the purpose here, many who lost government-supported jobs in the military or in munitions plants found employment as civilian industries expanded production — in fact civilian employment grew, on net, by over 4 million between 1945 and 1947 when so many pundits were predicting economic Armageddon.


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