The federal budget, interest rates, and savings gluts

The U.S. Congressional Budget Office yesterday released its updated Budget and Economic Outlook for the period between 2015 and 2025. As usually happens when CBO releases a document about the federal budget, most of the conversation focuses on the levels of spending and taxation the agency projects will happen in the future, particularly the difference between the level of spending and the level of taxation, better known as the budget deficit.

Perhaps a more interesting conversation would be about what CBO projects about the future path of interest rates, something that caught the eye of Matthew C. Klein at FT Alphaville. Despite CBO heralding increased budget deficits due to rising health care costs and an aging population, Klein sees that the projections of higher deficits are almost entirely about higher interest payments on debt the U.S. government already owes. In other words, the projections of a larger budget deficit are contingent on the path of future interest rates.

Specifically, CBO projects that the interest rate on a 10-year Treasury note will be 4.6 percent starting in 2020. For context, the 10-year interest rate in June 2007, before the damaged inflicted by the bursting of the housing bubble became apparent, was about 5 percent. And today the interest rate is about 1.8 percent.

Of course, very low rates today are a sign of concerns about economic growth outside of the United States, particularly in the European economies that use the euro. But how much higher can we expect long-term interest rates to rise? CBO projects that the 10-year rate will jump to 3.0 percent in 2015. There is cause to question such a quick pick-up in rates.

First, according to CBO’s own projections the overall growth rate of the economy is supposed to be below its potential growth rate for most of the 10-year window. Only in 2017 and 2018 does GDP reach its potential growth rate according to CBO. The rest of the time it’s below that rate.

Secondly, there are broader forces that inhibit rising long-term interest rates. The last time the U.S. Federal Reserve tried to raise interest rates, in 2004 there was no appreciable increase in the long-term rates. That phenomenon in part led then Fed Governor Ben Bernanke to coin the term “global savings glut” almost 10 years ago. The idea posits that the amount of savings in the global economy has increased so much that it has outpaced demand and interest rates across the world are held down. And while the source of the glut may be changing, it appears to still be around.

Of course, when talking about U.S. interest rates the decisions of the Federal Reserve have to be considered. Its policy-setting arm, the Federal Open Markets Committee, is currently meeting, but is not expected to start raising interest rates. Or at least not yet. But those moves should only affect short-term rates. As for the long-run, we all, including CBO, will just have to wait.