Many have asked when this level of debt will become a problem. The short answer is that this is really a matter of interest rates. Last fiscal year, net interest on the national debt was a manageable $345 billion, or 1.6% of GDP. However, this was achieved only because the federal government was able to finance its debt at the super-low rate of roughly 2%. If that average interest rate were to rise quickly in the years ahead, the government would have to increase borrowing significantly just to make payments on the debt. Maintaining fiscal stability depends, in part, on setting out a glide path to get back to budget balance. However, in the interim, it is crucial not to overheat the economy or overstrain the bond market in a way that triggers higher long-term rates or Fed tightening.
The Federal Reserve under Jay Powell has, of course, urged lawmakers to adopt aggressive fiscal stimulus since the start of the pandemic. The have also signaled that they won’t raise the federal funds rate until they have achieved their targets of inflation at 2% and on track to exceed 2% and maximum employment, which many have taken to imply an unemployment rate below 4%. They have also indicated that they won’t begin to taper bond purchases until “substantial further progress” has been made towards these goals.
At the December FOMC meeting, the Federal Reserve projected real economic growth over the course of 2021 of 4.2% with an inflation rate of 1.8% and unemployment in the fourth quarter of 5.0%. All other things equal, the Biden rescue plan should cause the economy to overshoot these forecasts on growth and inflation and cut the unemployment rate to well below 5.0%.
While the Federal Reserve will still likely retain a dovish tilt over the next few years, such an acceleration in growth could well trigger a more aggressive tapering of bond purchases, resulting higher long-term interest rates and a steepening of the yield curve.
What The Biden Rescue Plan Means For Investors
For investors, higher long-term rates would, of course, be a negative for long-term bonds and would make current stock valuations harder to justify. Faster economic growth in the short run could boost cyclical stocks and particularly financial stocks relative to defensives. Stronger wage growth from a hotter economy could eat into margins. While the rescue plan does not include higher taxes, the recovery plan later this year will likely include higher taxes on corporations and upper income individuals. It should be noted that there may not be 50 votes in the Senate for any tax increases in the short run. However, later this decade, if interest costs on the national debt start to become unmanageable, higher taxes may be inevitable. The more we borrow today, the greater will be those tax hikes in the future.
The plan would have mixed impacts on the dollar, with stronger near-term growth and a tighter monetary policy boosting the exchange rate, but greater consumer spending leading to a higher trade deficit and potentially weakening the dollar.
With current valuations at very high levels, 2021 already looked like a difficult year for financial assets. On balance, the Biden rescue plan, if implemented, could add to those challenges. That being said, before we are investors, or Republicans or Democrats for that matter, we are citizens of a world that has seen tremendous human suffering in the last year from a devastating pandemic. All of us should be rooting for an early end to that misery and the Biden rescue plan does appear to offer hope in that direction.
The problems that Bill Clinton confronted, when he entered the Oval Office 28 years ago this week, pale in comparison to the challenges that Joe Biden will face as president. But to paraphrase George H.W. Bush, his success will be our success. However we voted in the last election, we should all now be rooting for him to succeed.
David Kelly is chief global strategist at JPMorgan Funds.