Interest Rates Heading Up is no good for businesses or consumers, but often they’re inevitable. Here’s how you can prepare.
As the U.S. economy navigates a toxic mix of sluggish growth, high unemployment, rising inflation and trillion dollar budget deficits, increases in interest rates are a real possibility. Increasing rates are exactly what we don’t need. As interest rates go up, both consumers and businesses tend to spend less. People already in debt must divert money budgeted for other tasks to paying the additional interest. When the economy is in a precarious state, we want to stimulate spending not stop it.
The Federal Reserve has announced that it will keep the federal funds target rate at its current level of 0 percent to 0.25 percent. They have also revised downward their expectations for GDP growth for the remainder of 2011 and for all of 2012. If the target federal funds rate isn’t increasing then what other factors could lead to interest rates in the economy going up?
Foreign buyers may not be able to keep financing our deficits
The U.S. Federal government is expected to run a budget deficit in excess of $1.4 trillion this fiscal year. Like any organization that runs a deficit, the U.S. Treasury borrows billions of dollars every month to plug the hole. The monthly hole that the Treasury must fill through borrowing boggles the imagination. This year it has fluctuated between a low of $40 billion in April and a high of $222 billion in February. Last month it was over $57 billion.
Up until now a significant portion of these deficits have been financed by foreign governments that consider the U.S. government to be the best credit risk in the world. The number one holder of U.S. debt is China, which as of April holds approximately $1.15 trillion in U.S. debt. Japan is a close second with nearly $907 billion. Total holdings by foreign governments are approximately $4.9 trillion.
Taking a closer look, however, there is a disturbing trend. Over the past year the net purchases of U.S. securities by foreign governments has decreased significantly. During the last half of 2010, foreign governments increased their holdings of U.S. debt by an average of $61 billion per month. This year the total increase so far has been only $51 billion, an average of less than $13 billion per month.
Doubts about the U.S. government’s ability to manage its debt and opportunities for domestic investment in countries like China and Japan may make it more difficult for the U.S. to continue to attract sovereign investors. From a diversification point of view, many countries are already saturated with dollar reserves and are actively investing in other currencies.
Private investors will demand higher rates of interest from the government
As the federal government looks to finance tens of billions of dollars each month, they will most likely increase their reliance on insurance companies, pension funds, hedge funds, and other large institutional investors. These investors, however, will demand higher rates of interest than the sovereign investors.
