InvestMacro

By Gerald P. Dwyer, Clemson University 

Consumers and businesses aren’t the only ones feeling the pain of higher borrowing costs because of Federal Reserve rate hikes. Uncle Sam is too.

The U.S. government spent a record US$213 billion on interest payments on its debt in the fourth quarter, up $63 billion from a year earlier. Indeed, a jump of almost $30 billion on the previous quarter represents the biggest quarterly jump on record. That comes as the Fed lifted interest rates a whopping 4.25 percentage points from March through December.

As an economist, I am concerned that the effect of higher interest payments on the government’s budget is being ignored. Higher interest payments mean the federal government will either have to lower spending, raise taxes or issue more debt to service its obligations. And financing interest payments by issuing more debt could be a particularly poor choice – sooner or later, the bill will come due.

The national debt – the amount the federal government borrows to balance the budget – increases when spending is greater than revenue and accumulates over time. As a general rule, it increases over time because of increases in spending, revenue and the deficit. Inflation tends to increase government spending, as well as revenue and deficits. As a result, the dollar value of government debt increases in times of inflation. Debt also tends to grow as the economy gets bigger – although this is not inevitable as policymakers could choose to balance the government’s budget.

In this way, total government debt has climbed over the years – by the end of 2022 it was 10 times larger than it was in 1990. It currently stands at over $31 trillion dollars and represents more than 120% of the nation’s gross domestic product. GDP is the total annual amount of goods and services produced by a country and often is used to judge whether debt is high or low.

Since 1990, government debt has more than doubled relative to the size of the economy – indicating that servicing debt could be quite a bit more of an issue than it once was.

A decade of record-low borrowing costs

But how concerning are these numbers? After all, it is not as if the government debt has to be paid off every year.

Government borrowing has some similarities to a person paying for an expensive item with a credit card, with the actual amount due to be paid off over an extended period. Just as with purchases on credit, interest is applied – and can add to the overall outlay. The federal government is different from consumers, though – it need not pay off its debt for the foreseeable future.

In terms of interest payments, the U.S. has been fortunate in recent years. Historically low interest rates since the 2008 financial crisis have held down interest payments. And just as low interest rates encourage would-be homeowners, for example, to take out a larger mortgage, they have also made it much more attractive for the federal government to borrow money to pay for whatever Congress and the administration want to finance.

But then came 2022. Soaring inflation – which reached levels not seen in 40 years – meant an end to the days of near-zero interest rates. To restrain inflation, the Fed raised rates seven times in 2022, taking the base rate from near zero to a range of 4.25% to 4.5% at the end of 2022. It is expected that the Fed will raise rates by a further 0.25 percentage point at its next monetary policy meeting starting Jan. 31. Projections made by Federal Board members indicate that, with future increases, rates will average 5% or more in 2023.

Not all government debt, however, carries these current higher interest rates. Just as with typical U.S. mortgages, much of the government debt bears the interest rate applied when it was taken on. The difference is, unlike homeowners, the government does not pay off its debt. Instead it rolls over old debt into new debt – and when it does so it takes on whatever the interest rate is when the debt is rolled over. And when this happens and interest rates have risen, the cost of servicing the overall debt goes up.

There may be trouble ahead

The federal government’s interest expense has only begun to reflect the higher interest rates. The average rate the U.S. paid in 2022 was just over 2%, which is up from the 1.61% average in 2021 but still lower than it’s been over much of the past decade. But even so, the effect is being felt. Since the Fed began hiking rates, the U.S. government’s exposure to debt interest has climbed sharply.

It may all sound a little worrying, especially amid talk of a recession – it is as if the interest on your credit card or mortgage suddenly jumped at a time when you were facing a possible cut in wages.

But there are some reassuring economic projections as well. Inflation declined substantially in the second half of 2022 and appears likely to be under control. And there is good reason to think that interest rates of 4% – or even less – are in the U.S.‘s future, as well as in the Federal Reserve projections. Whether there will be a “soft landing” in the economy – that is, a slowdown that avoids a recession – is not so obvious. While it is not inevitable, many indicators point to a recession in 2023.

Either way, the days of borrowing trillions of dollars at near-zero interest rates to finance extravagant spending are over for the foreseeable future.

About the Author:

Gerald P. Dwyer, Professor Emeritus of Economics and BB&T Scholar, Clemson University

This article is republished from The Conversation under a Creative Commons license. Read the original article.

By George Prior

Investors are set to largely shrug off hawkish tones and rate rises from the Federal Reserve moving forward, predicts the CEO of one of the world’s largest independent financial advisory, asset management and fintech organizations.

The prediction from Nigel Green of deVere Group, comes as the U.S. central bank’s policy-setting Federal Open Market Committee (FOMC) raised rates by 25 basis points at the conclusion of its two-day meeting, bringing its benchmark to a target range of 4.5% to 4.75%.

The deVere Group CEO observes: “The markets expected a 25bps rise, which is another step downward for the Fed, which increased rates by 50 basis points in December, following four 75 basis-point hikes in 2022.

“The Fed went strong on flagging worries about financial conditions becoming too loose, and that whilst progress on taming inflation has been made, officials remain concerned.

“The central bank delivered hawkish tones about rates having to remain higher for longer and reiterated the Fed’s commitment to cooling inflation.”

However, says Nigel Green, “There’s set to be some fluctuation, but moving forward markets are going to largely shrug off the Fed’s hawkish tones and rate rises.”

He continues: “Markets typically look to the future, not at the present, and will see that inflation has peaked, and the growing signs of a ‘soft landing’ for the U.S. economy as it appears that the central bank is reducing inflation without creating significant unemployment.

“There’s a sense that things are actually better than the Fed is admitting to, in order to stop over-exuberance of the markets.

“The Fed’s rhetoric doesn’t appear to be changing, despite the data, and the markets are aware of this.”

As the U.S. central bank steps down from the aggressive tightening agenda, markets are increasingly “going to overlook the Fed’s rate increases; they’re becoming less relevant.”

Nigel Green affirms: “Savvy investors know that now – in a year in which there will be big winners and big losers – it’s about being invested in the right companies, those which can consistently maintain or steadily grow margin, as well as diversification across sectors, asset classes and regions.

“A good fund manager will be critical in identifying these winners and losers as the economic cycle moves on.”

About the Author:

deVere Group is one of the world’s largest independent advisors of specialist global financial solutions to international, local mass affluent, and high-net-worth clients.  It has a network of more than 70 offices across the world, over 80,000 clients and $12bn under advisement.

By Marc-Andreas Muendler, University of California, San Diego and Carlos Góes, University of California, San Diego 

Even when they’re in trouble, Brazilians rarely lose their sense of humor. But in recent years, their joviality has often given way to political division everywhere from social media to the dinner table.

One familiar quip – that Brazil is the country of the future and always will be – has lost its levity as Luiz Inácio Lula da Silva begins his third presidential term. Lula previously led his country from 2003 to 2010. The president, who was sworn in again on Jan. 1, 2023, promised on the campaign trail that Brazil’s future can be like its past again: more prosperous and less polarized.

Having studied Brazil in our economic research, and having lived in the country for several years by birth or by choice, we argue that it will not be easy for Lula to fulfill his economic promises.

Unlike in his first two terms, when domestic and foreign markets helped the economy along, Lula now faces strong headwinds at home and abroad – and that means sound policies are even more important this time around.

Good times, bad times and economic choices

Brazil shot up from the world’s 14th-largest economy in 2003 to the seventh-biggest in 2010, during a boom that largely coincided with Lula’s prior presidency. At the same time, the country’s poverty rate, which the World Bank today pegs at the share of the population living on less than US$3.65 a day, fell sharply, from 26% to 12%.

Brazil exports so many gallons of orange juice, bags of coffee, bushels of wheat and other commodities that it’s serving up the world’s breakfast. Global growth during those years boosted the demand for these commodities as well as for Brazil’s processed goods. Manufacturing exports fueled Brazil’s growth in the decade following the year 2000 for the first time, led by sales of products like steel, car parts and cars, and aircraft made by Embraer.

During these boom years, Lula ran a balanced government budget, held inflation low and kept the Brazilian real’s exchange rate with other currencies under control – macroeconomic policies that he maintained from his predecessor, Fernando Henrique Cardoso. Lula also bundled Cardoso’s popular anti-poverty programs into Bolsa Família, a successful conditional cash transfer program. To remain enrolled and receive the monetary benefits, low-income families had to get their children vaccinated against diseases, keep them in school and meet other requirements.

Cynthia Benedetto, Embraer’s chief financial officer, observed in 2011: “Since my childhood I heard that Brazil is the country of the future,” and then warned, “Now the future has arrived, and I start to fear that it is short.”

She was right. The good times didn’t last.

During the second decade of this century, the prices of many of the commodities that Brazil exports fell or even plummeted. The country experienced two of the worst recessions in its history. In the downturn that lasted from late 2014 to mid-2016, nearly 5 million Brazilians lost their jobs. After a sluggish recovery, the COVID-19 pandemic hit, and 10 million Brazilians became jobless in another big downturn.

Political upheaval

Bad choices made tough and unlucky times worse.

A combination of economic mismanagement, widespread corruption, political turmoil and a global pandemic all contributed to 10 years of backward sliding after a decade of progress.

Lula’s allies, including some in his inner circle, were found to be part of one corruption scheme after another. Lula himself ended up in prison for corruption until Brazil’s Supreme Court declared the case a mistrial because the presiding judge was determined to have been biased.

Brazilians elected Lula’s hand-picked successor, Dilma Rousseff, in the 2010 and 2014 presidential races. She cast aside some of her predecessors’ policies that had buttressed economic stability.

Rousseff ended the central bank’s de facto independence and lowered interest rates in an abrupt turnaround that sparked inflation. She gave up on balancing the budget.

Once corruption was exposed in state-owned oil company Petrobras, the construction industry and at Brazil’s massive state-run development bank, economic activity slowed across the board. Rousseff oversaw one of Brazil’s most severe economic contractions in memory: GDP shrank by 7% and public debt increased 20 percentage points as a share of GDP from 2014 to 2016.

Brazil’s Congress impeached and convicted Rousseff in 2016 for fiscal improprieties. Her vice president, Michel Temer, served out the rest of her term and appointed Lula’s central bank chair, Henrique Meirelles, as minister of finance to help rein in public debt.

Jair Bolsonaro, a vocal admirer of Brazil’s 20th-century military dictatorship, became president in 2019 by riding the wave of widespread sentiment against Lula’s and Rousseff’s Workers’ Party. Bolsonaro prioritized short-term political gain over long-term adjustment, often clashing with his own economic aides and dodging rules meant to curb government spending.

By 2020, Brazil’s economy ranked No. 12 in the world in terms of GDP, and living conditions deteriorated. In 2021, the poverty rate likely hit the highest level in a decade, according to estimates by researchers at IPEA, a government think tank, as well as IBGE, Brazil’s statistics agency.

The pandemic and the social spending fluctuations it brought about have made it hard to accurately track economic trends in recent years. But the numbers suggest that Brazil is close again to where it started the 21st century.

Back to the future

Lula’s economic challenges are daunting, over and above the political crisis after the riots by opposition supporters in Brasília.

First, the economic outlook is gloomy. Inflation has led central banks worldwide to increase interest rates, and the International Monetary Fund forecasts a global slowdown in 2023.

Even if the world still wants Brazil’s coffee, orange juice and cereal from wheat or corn for breakfast, we doubt that foreign demand for Brazil’s exports will bounce back to the levels seen in past boom years.

Global prices for many of the commodities Brazil exports have been sliding downward for the past 15 years. They briefly reached their 2008 peak level again in mid-2022, partly driven by Russia’s invasion of Ukraine and the ensuing global turmoil that drove food prices up.

But the prices of commodities that are particularly important to Brazil, such as soybeans, corn and coffee, are all down significantly from their recent peaks.

During his 2022 campaign, Lula promised to slash taxes on the upper-middle class and increase benefits for the poor while keeping government finances under control.

This arithmetic is feasible in an era of rapid growth, when newly generated wealth can finance public transfers. At times of slow or no growth, like today, it becomes much harder to pull off.

Second, unlike when Lula first took office following a period of fiscal stability, this time he must credibly rebuild much of the fiscal framework.

After boosts to benefits, tax cuts and some unfunded pension commitments to retirees, it’s become hard to balance Brazil’s budget. In response to the crisis in the mid-2010s, Brazil’s Congress passed a spending cap that gradually rises so as to foster slow fiscal adjustment while avoiding harsh austerity. But Bolsonaro essentially got rid of the cap by circumventing it.

One example is the federal government’s obligation to cover court-mandated payments: Bolsonaro delayed the disbursement of 110 billion reais ($21.6 billion), equal to more than 1% of Brazil’s GDP, in 2022. That means the new government has to pay this year’s and some of last year’s bills at the same time.

While Bolsonaro dismissed the severity of COVID-19 when it was spreading uncontrolled through his country, his government did help people cope with its economic fallout by allowing emergency spending that breached Brazil’s spending cap. However, his administration maneuvered to perpetuate the state of emergency and kept spending levels higher than the cap would allow long after Brazilians stopped staying at home for public health reasons.

Third, we expect political divisions, including some within Lula’s administration, to be another obstacle. Different factions on his economic team are likely to be at loggerheads for the foreseeable future because they prefer starkly different policies.

Simone Tebet, the new economic planning minister who is in charge of coordinating spending, has several fiscal conservatives on her team.

Finance Minister Fernando Haddad, in contrast, has appointed undersecretaries known to invariably advocate for more spending. Plans for taxes and spending released to date set a budget surplus of 0.5% of GDP as the new government’s target, primarily financed with more tax collection.

Using budget projections by the International Monetary Fund, we consider those revenue projections overly optimistic.

To be sure, any new government deserves time to prove itself, especially under tough circumstances. But patience is rarer in Brazil than humor – and always has been.

About the Author:

Marc-Andreas Muendler, Professor of Economics, University of California, San Diego and Carlos Góes, Doctoral Candidate in Economics, University of California, San Diego

This article is republished from The Conversation under a Creative Commons license. Read the original article.