The New Normal: Rising Interest Rates

U.S. Treasury Department

The United States enjoyed a three-decade decline in interest rates, beginning with the early-1980s quashing of inflation by Federal Reserve Board Chairman Paul Volker and culminating with Ben Bernanke’s Quantitative Easing in the mid-2010s. Lower interest rates, which made equities look more favorable by comparison, helped drive stock market indices like the Dow Jones Industrial Average and the S&P 500 to record highs.

Now the age of declining interest rates is over. Dead. Pound the nail in the coffin. Dig the grave.

The implications of this seismic shift are dire for the world’s largest debtor, the U.S. federal government. But state and local governments have cause for concern, too.

The manic bull market for stocks took its first big drubbing earlier this week when U.S. Treasury yields took an unexpected uptick. It is finally dawning on financial markets that as good as the Trump tax cuts may prove to be for the economy, they will increase federal budget deficits and borrowing, which will pressure interest rates higher. Even accounting for a stronger economy that pumps up tax revenues, nonpartisan groups say the tax law could add $1 trillion to deficits over the next 10 years.

Meanwhile, the Treasury Borrowing Advisory Committee has estimated that the Treasury will need to borrow a net $955 billion in the fiscal year ending Sept. 30, 2018, up from $519 billion the previous year. Borrowing will increase further to $1,083 billion next year and $1,128 billion the following year. That’s with a strong economy, not a recession.

The Treasury borrowed even larger sums back in 2009 and 2010 as the U.S. economy struggled to pull out of the global recession. But the economic picture looked very different back then, allowing the U.S. to finance $1.6 trillion annual deficits without driving interest rates higher. As the Wall Street Journal explains:

Back then, global demand for safe assets was high and investors gobbled up U.S. Treasury issues, pushing up Treasury prices and down their yields. The Federal Reserve had also cut short-term interest rates to near zero and was beginning a series of programs to buy government debt itself, putting further upward pressure on Treasure prices and downward pressure on interest rates. …

Treasury’s increased borrowing now comes against a much different economic and financial backdrop. The economy is strong and inflation is expected to rise gradually in the months ahead. In response, the Fed is pushing short-term interest rates higher and allowing its portfolio of Treasury and mortgage debt to shrink as bonds mature.

Another factor, I might add, is the weakness of the dollar, which also discourages foreign purchases of U.S. debt and adds to inflationary pressure.

Why am I writing about the end of the era of low interest rates in a blog dedicated to Virginia public policy? Because state and local governments, colleges, universities, economic development authorities, and public service entities are big borrowers, too. Higher interest rates makes life harder for all of them.

To draw from the latest headlines, Mayor Levar Stoney wants to increase the City of Richmond meals tax to fund school building improvements because the city has maxed out its debt capacity and can borrow no more without undermining its AA bond rating. Likewise the Commonwealth of Virginia has borrowed close to its cap, constraining the state’s ability to issue new debt.

Virginia policy limits annual service on its long-term debt to 5% of General Fund revenues. Debt service can be broken into two main parts: the principal borrowed and the interest paid. It is axiomatic: If interest rates increase, so does the annual debt service…. Which means the state can borrow less.

Most important of all, Virginia has a massive unfunded pension liability. That liability, about $20 billion now, has shrunk modestly in the past couple of years thanks to the strong performance of the Virginia Retirement System (VRS) equities portfolio. The next VRS report, reflecting results from the astonishing Trump-era bull market, likely will be positive. Virginia, it will appear, is making continual progress in whittling down its liabilities. No one will be concerned.

But the stock market cannot possibly extend the past decade’s performance into the future. While earnings may continue to improve, stock prices will be dampened by interest rates and shrinking price-earnings multiples. Do not be deceived. The turning point in the bond market does not augur well for either the United States with its $20 trillion national debt or Virginia with its more modest obligations.

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16 responses to “The New Normal: Rising Interest Rates”

  1. LocalGovGuy Avatar

    I would not worry nearly as much about VRS as some are. We’re at the Baby Boomer retirement stage (Boomergeddon) right now. This is the big hit to VRS.

    But, a lot of actuaries are starting to wonder about gov’t pension obligations in the future in a more optimistic way. Fewer Gen Xers (compared to Baby Boomers) are staying with state/local gov for 30-40 years and retiring (except teachers). Millennials less than X, and while it’s too early to tell about Gen Z, they seem much more restless than Millennials.

    Not to mention that most of X, and all of the Millennials and Zs, even if they stay for 30-40 years, now have a multiple of 1% of three highest years of salary times years of service compared to the old 1.7% times years of service for the Boomers under VRS.

    I suspect that in 10 years, once we get a full picture of just how few of these younger generations are going to make a career out of gov’t work, we’ll be talking about VRS surpluses. Just a hunch…

      1. LocalGovGuy Avatar

        I do too.

        While I know a small subset, I just don’t see people under 50 making careers out of gov’t (except teachers). In fact, I only know of one person under 50 who is a “career bureaucrat.” X, Y, and Z may work for the gov’t for a couple of years, but they’re not sticking around for decades. It’s hard to believe that those generations are going to be anywhere near the burden on gov’t pension funds that the Boomers are.

  2. djrippert Avatar

    “Most important of all, Virginia has a massive unfunded pension liability. That liability, about $20 million now …”

    I assume you meant billion instead of million.

    1. You assume correctly.

      Correction made.

  3. TooManyTaxes Avatar

    At least the Commonwealth took a positive step towards fiscal responsibility a couple years ago when it changed the VRS from a defined benefit plan to a combination defined benefit and defined contribution plan for new employees. Not sure if this change also affected non-vested employees. This combination plan is similar to the federal FERS program adopted decades ago.

    Fairfax County, on the other hand, still has defined benefit plans for county employees, police and uniformed employees. Teachers are under VRS. Also, the County has a second defined benefit plan for county employees that gives them the equivalent of Social Security benefits from early retirement to normal SS retirement age. But the Schools are even more generous with their second pension plan. They offer employees the SS equivalent from early retirement until death. No other local government entities in Metro Washington have such generous and costly plans that are eating tax dollars like crazy.

    The McLean Citizens Association has been raising the fiscal alarm bell on the local pension problems for several years. The supervisors and school board are sticking their toes in the water towards reform, but are still failing to address this huge and growing problems. The MCA effort was spearheaded by an individual who ran the pension programs for both Mobil Oil and AMTRAK for decades before he retired.

  4. Easy money is supposed to make borrowing capital easier, therefore easier infrastructure improvements and other investments in the future. But how can anyone do that, responsibly, before these looming unfunded liabilities are tamed first? Particularly in places like Fairfax County?

  5. LarrytheG Avatar

    see .. there’s a little bit of a disconnect her on the gloom and doom, unfunded pensions and… AAA or even AA credit ratings.

    How can any localities be “in trouble” on pensions – if they have a AAA credit rating? Ditto for the State… Virginia is in a select group of states that has an AAA credit rating so apparently the folks who do the ratings Don’t see Virginia (or Fairfax) in fiscal peril.

    so what’s the deal? Just how “bad” can unfunded pension liabilities be if the Credit Ratings folks rate you AAA?

    1. TooManyTaxes Avatar

      Larry, rating agencies, including Moody’s, were close to downgrading Fairfax County’s AAA bond rating for several reasons, including inadequate reserves, weakness in growth in the real estate tax base and excessive pension liabilities. It scared the crap out of most supervisors.

      The linked resolution shows the situation as of January 2017. I believe the MCA’s resolution on the FY 2019 Fairfax County budget will update the pension figures.–%20Fairfax%20County%20Pension%20Costs.pdf

      For example, look at FY 2106, the County (funder of both county and school pensions) increased cash payments and assumed more unfunded debt for a total of almost $1.1 billion. That’s just one year. Shown as a function of real estate taxes (calculated at $23 million per penny), that’s almost 49 cents of the real estate tax rate of $1.09.

      That is simply not sustainable. Couple that with the needs to raise teacher salaries to be more competitive in the Metro market, WMATA’s needs, the ever-growing number of poor kids in FCPS, and the movement of wealthier and higher paid residents out of Fairfax County and the County is on the road to big problems.

      1. LarrytheG Avatar

        All in all though TMT – the credit agencies are still pretty much okay with Fairfax..and they do look further downstream.. I’ve heard those Davenport guys give presentations down at Spotsylvania and they lay it all out in the out years.. so AAA is still AAA and actually AA is not disastrous..

        Only about 7 counties in Va get AAA.. and quite a few rural ones have truly terrible ratings .. no due to fiscal sloth but their lack of capacity to raise adequate revenues to pay their bills.

  6. Steve Haner Avatar
    Steve Haner

    “But the stock market cannot possibly extend the past decade’s performance into the future.” Give back the diploma, Jim – or at least, go look up the Dow at the time you went to Mr. Jefferson’s fine school….The Dow Jones first closed above 500 in our lifetimes. Now 26,000+. Any doubt our grand kids will see 50,000? Absent WWIII of course…

    You are of course correct that higher interest rates have consequences, but you seem to ignore some are positive.

  7. Jim we had a helluva a day in the markets on Friday so you’re article was timely. Obviously we have the market pundits making a move to sell bonds, trying to get “ahead of the trends.” But as usual we have to wait to see if the popular notion of increasing rates (a popular notion since 1980 but so far the opposite has happened) is true or anti-bond hype as usual. We are in a deflationary cycle (low rates) but someday it will really end. When, we do not know, but of course, we know what the pundits think at the moment, and sometimes we have to follow the herd. Short term rates are rising (by the Fed) but an inverted yield curve is possible.

  8. LarrytheG Avatar

    Yep. You’d think that the pension funds as well as people’s individual 401Ks would be cleaning up in this stock market!

    the thing is there are cycles and in most of our lifetimes, we’ve seen at least one really bad meltdown.. so the Gloom and Doom folks are not irrational.

    But if you look around the Country .. Virginia’s unfunded pension obligations just don’t look that terrible …unless of course you don’t believe the credit rating folks.

    here’s another interesting chart:

    1. TooManyTaxes Avatar

      It will be interesting to see what local governments have to say about the state of their pension funds from stock market gains in 2017. Back in the late 1980s to the mid-1990s, my then employer rarely had to fund its pension plan because of earnings. If we continue to see economic growth pick up and the stock market maintain its upward motion or, at least, a trend in that action, all will benefit.

      One of the problems affecting many public sector pension plans has been overly optimistic assumptions about economic growth and expected RoRs.

      But, in the long term, with people living longer, the public sector will need to move from all defined benefit plans like the Feds did decades ago.

  9. LarrytheG Avatar

    Will the big stock market gains – have the effect of improving the credit ratings of the states?

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