Ok, the Fed finally hiked rates by a whooping 1/4% ….
A common view: “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 likely to be the major impact?
Here’s my take…
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.
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 pretty big deal right?
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.
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
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.