U.S. interest rates may pose risk to Trump budget's optimistic assumptions

Wed May 24, 2017 3:56pm EDT
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By Howard Schneider

WASHINGTON (Reuters) - If President Donald Trump's budget does touch off an economic boom that pushes growth up to 3 percent a year as it assumes, the government's borrowing is likely to cost much more than has been factored into the administration's fiscal proposals.

Along with costing the government more, rising rates could crimp spending among households and companies, cutting into the very growth that the administration is counting on to eliminate government deficits over the next decade.

Economists say there is a rough, but direct, tie between economic growth and the 10-year Treasury bond used as a benchmark in government budgeting. If the U.S. economy did shift into a higher gear and begin growing at 3 percent on a sustained basis, Treasury bond yields would likely move far beyond the 3.8 percent rate the administration has assumed - possibly edging towards 5 percent based on historical data.

That would push the Federal Reserve into a broad reassessment of its own policy that has so far been one of incremental and slow interest rate rises to keep the economy growing.

"The rough rule of thumb is that the average 10-year yield should be sort of close to (gross domestic product) growth," which in the current budget would be 5 percent including an assumed inflation rate of around 2 percent, said Paul Ashworth, chief U.S. economist for Capital Economics.

"Trump's budget is a return to the pre-financial crisis world," where the rate curve from the Fed's overnight lending to the longest-term bonds were higher across the board, he said.

The net effect on interest rates would be complex, hinging on whether government deficits do in fact decline as the administration contends - a fact that would offset the higher cost of issuing new bonds - and how the higher interest rate environment affects economic growth.

It would also depend on how the Fed reacts, and whether inflation in that environment remains a tame and steady 2 percent.   Continued...

A copy of President Trump's Fiscal Year 2018 budget is on display on Capitol Hill in Washington, U.S., May 23, 2017.  REUTERS/Kevin Lamarque