Growth at What Price?
With the tax season so recently behind us, and as we all adjust to a new tax regime, US interest rates are beginning to reflect the upcoming decline in federal tax revenue. Economist Milton Friedman advocated “cut taxes under any circumstances,” but he also recognized the importance of controlled spending.
We think our government has lowered taxes without any spending restraint, and financial markets are beginning to price in some of the consequences. Low interest rates have helped keep asset prices elevated and aided in the recovery from the 2008 financial crisis. We think the current market is particularly susceptible to a dramatic interest rate increase.
Any institution or individual that knowingly cuts revenue and borrows to finance the shortfall must hope for much stronger growth to wipe out the imbalance, or accept higher inflation and thereby devalue the debt. For the US, which is already growing at a strong pace, the imbalance is likely to become more expensive as interest rates increase, ultimately hindering growth. This is a recipe for short-term success but long-term difficulty, in our view.
US tax reform, while benefiting US corporations and individuals, will come at the expense of a rising US budget deficit as tax revenue decreases. Consequently, we expect the level of Treasury bond issuance to rise as the government borrows more to meet its obligations, leading to additional pressure on interest rates.
[For more, see our Q2 2018 Economic Outlook.]