Chart of the Month (September 2024)

Chart Description – Top Chart

• The solid blue line shows net federal interest payments from 1960 to current (leftscale).
• The dotted blue line shows the Congressional Budget Office (CBO) projection for netinterest payments over the next 10 years.
• The solid orange line shows net federal interest payments as a % of the US Economy(GDP) (right scale).
• The dotted orange line shows the CBO’s projection for net federal interest paymentsas a % of GDP over the next 10 years.

Chart Description – Bottom Chart

This is table 1-3 from page 25 of the CBOs report released on June 18, 2024, titled,“An Update to the Budget and Economic Outlook: 2024 to 2034.”

As shown, the CBOs report assumes that Gross (public and government owned)debt grows by $21.78 trillion by 2034 to a total of $56.85 trillion.

The CBO is assuming that the public will acquire 103% of the increase as the debtheld by the public line item grows by $22.47 trillion to $50.66 trillion in 2024.

The implication is that the Federal Government (Federal Reserve, trust funds, etc.)will own slightly less government debt in 2034 than it does today.

The CBO assumes that the average interest rate on debt held by the public willremain constant at 3.5% throughout the 10-year period.

Our Take

Two weeks ago, the Chairman of the Federal Reserve, Jerome Powell, delivered a muchanticipated speech to conclude the Fed’s annual symposium in Jackson Hole, Wyoming. The main takeaway from his speech was that, from the Fed’s perspective, inflation is now under control, and therefore the Federal Reserve Open Market Committee (FOMC) will begin cutting interest rates in September. The financial media views this shift as generally favorable for the economy and financial asset prices. We wonder if there is greater concern about the economy and the employment picture behind the closed doors of the Eccles Building than what Jay Powell is letting on. Only time will tell.

Other than patting himself and the rest of the FOMC on the back for conquering inflation, a good portion of Powell’s Jackson Hole speech attributed the rapid rise in inflation to the supply and demand shocks following the Covid-19 lockdowns. While those factors no doubt played a meaningful role in the short run, we find it interesting that he completely failed to mention the true definition of inflation, and the single most important factor that can be directly linked to an increasing price level in almost every major period of inflation since the Roman empire. Inflation means to inflate the supply of money. Price increases are merely a symptom and occur when the supply of money in circulation increases at a much faster rate than the growth in the economy (production of goods andservices). Unencumbered control of the money supply rests in the hands of Jerome Powell and his colleagues on the FOMC. The fact that Chairman Powell didn’t utter a word about money supply during his speech was an unintentional oversight, we’re sure.

We disagree with Chairman Powell’s assessment that inflation has been conquered once and for all. The chart and table above touch on a few of the key areas that lead us to believe that we are simply in the eye of the inflation storm. Looking at the top chart, net federal interest payments are projected to eclipse national defense spending and finish fiscal 2024 (Sept) at just under $1 trillion. This does not include the interest that the federal government pays to itself for money that it borrows from itself (take a moment to think about that). Net interest payments are projected to grow by over 70%, with what we would argue are rosy assumptions, to over $1.71 trillion or 4.1% of GDP in 2034. Add to that the ballooning cost of social security, Medicare/Medicaid and national defense and we are all but assured of a spiraling budget deficit.

As mentioned above, we believe the CBO assumptions are optimistic to say the least. Here is a summary of the important assumptions driving the CBO’s estimates:

1. No recession between now and 2034.
2. Inflation moves down to the Fed’s target of 2% by 2026 and stays there through2034.
3. The annual deficit is almost double the average of the last 50 years at nearly 7% peryear but remains stable at that level.
4. Discretionary spending declines as a percentage of GDP over the next 10 years.
5. Public debt held grows by over $22 trillion (79% increase) by 2034.
6. Interest rates remain low and stable
   a. The assumed average rate paid on publicly held debt is 3.5%
   b. The 10-year treasury is 4.1% in 2034

While we have no objection to taking a “glass half-full” approach, some of the assumptions listed above seem to be mutually exclusive. For example, the assumption that there will be overwhelming demand from the public to acquire an additional $22 trillion of government bonds, over and above the $28 trillion that is already owned, at a modest average interest rate of 3.5% seems highly unlikely

Much of the new issuance over the last few years has been in short-term T-bills offering a rate of 5% plus. Investors have been more than happy to soak up that supply with a guaranteed rate from the US government that is greater than what most banks have been able to offer. However, those rates will come down quickly as the Fed begins to lower rates this fall. There is some debate as to how far rates will come down and how quickly, but at the margin we know the rate will be less attractive than it has been. Based on fundamental economic principles, we know that investors will be less eager to buy newly issued T-bills when the rates drop. Some of the dollars that had been invested in Tbills will look for other investment opportunities.

Now apply that same economic principle to the CBO’s projection. The CBO is essentially telling us that long-term rates will not move up at all over the next 10 years, yet there will be an overwhelming investor demand to soak up an unprecedented amount of new supply. That defies common sense. The only way to create the level of demand that is needed to soak up the projected supply is to incentivize investors with higher rates. For example, investors may be more willing to fund the government’s growing debt at an average rate of 4.5% compared to the 3.5% used in the report. That may help with the demand side of the equation, but an increase in rates will throw fuel on the deficit fire. A relatively small increase to the average rate of 1% on $50 trillion of outstanding debt would result in a significant hit to the bottom line of the federal budget by increasing interest expense by $500 billion. A higher interest expense would increase the deficit. A higher deficit results in more borrowing and ultimately even higher rates to incentivize investors to soak up even more supply. Therefore, it is easy to see how the government could fall into a very difficult debt spiral if market forces are allowed to play out.

The more likely scenario, in our opinion, is that the Federal Reserve will begin purchasing government bonds again in the future to soak up some of the supply and keep rates low. Where will they get the money, you ask? Well, they will simply press a key on their keyboard and create it out of thin air. Monetizing the debt is how the US Government was able to pay for the bailout programs during the great financial crisis, and more recently the covid-19 pandemic. This approach allows the government to have their cake and eat it too in the short run. However, inflating the money supply is also the direct cause of the cost-of-living pain that Americans have felt in recent years. Everything the Fed and politicians talk about focuses on the symptoms of inflation as opposed to addressing the real problem. Now Jay Powell tells us the inflation ballgame is over, but from our viewpoint it is still early innings.

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