Fed Watch: Is 1/4 of 1 percent a big number or a little number ?

Last week’s Federal Reserve action (err, make that inaction) caused a stir in the financial markets.

Common view was: ” geez, is the economy so bad that it can’t absorb a measly 25 bps increase in interest rates?”

Obviously, .25% isn’t enough to sway many corporate investment decisions … most corporate investments are projected to return mucho above the firm’s cost of capital …  not mere quarters of a point.  Reality is that firms have hurdle rates way above their cost of capital, reflecting implicit risk and organizations’ limited implementation capacity.

So, what’s going on with the Fed’s decision?

Some pundits are arguing that the Fed is just trying to prop up the stock market with low rates that force investment into higher risk intruments (i.e. stocks)..

That may be true, but it doesn’t seem to have done the trick last week.

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I think that there’s something else going on … something that I haven’t heard from any on-air pundits …

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Anybody remember the U.S. National Debt?

Well, it’s now over $18 trillion.

Now ask yourself: “How much would a additional .25% interest rate increase the annual cost of the U.S. debt?”

Let’s do a “gross” back-of-the envelope calculation:

A basic math principle:  A little number  times a very big number results in another very big number.

In this specific case,  $18 trillion times .25% equals $45 billion.

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Currently, the U.S. pays about $425 billion in interest to “service” the national debt. Source

Given the recent low interest rates, the average interest rate paid on the debt  is about 2.5%

So, a .25% hike bumps that rate up by 10%.

Sounds like a bigger deal, right?

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Let’s put that number in another context ….

The CBO estimates that ObamaCare costs about $100 billion annually.

So,  a .25% increase in interest rates equals about 1/2 of a year of ObamaCare.

Hmmm.

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I know that some folks will claim that I’m overstating the case since a rate hike wouldn’t immediately and directly hit the full $18 trillion since the debt has an average maturity of about 5 years.

Said differently, only about 1/5th of the debt would get quickly hit by the higher rates.

So, the near-term cash flow  impact is only about $9 billion.

Still, that’s a statistically significant number.

And, the “economic cost” (versus cash flow cost) is theoretically the full $45 billion

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The politics …

This was a September rate decision, right?

What’s special about September?

Oh yeah, the Congress and Administration are haggling over the FY 2016 budget.

Imagine if the budget had to reflect a previously unrecognized rate increase on the national debt?

Probably would cause some political tension, right?

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Takeaway

Again, always remember that a little number times a very big number usually results in another very big number.

Put numbers in context and .25% suddenly doesn’t sound measly …. it sounds significant and, oh yeah, awfully political.

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#HomaFiles

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