May 24, 2017 / 6:45 PM / 4 months ago

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

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

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.

The Treasury rate projection is just one of a number of assumptions in the Trump budget that economists have criticized, with the assumed return to 3 percent growth regarded as notably unrealistic.

Trend U.S. growth is currently considered to be around 2 percent, low by historic standards but now regarded as a likely norm in an economy that is aging, and in which the annual growth in worker productivity has slowed.

TRILLION-DOLLAR PROBLEM?

In the aftermath of the 2007-2009 financial crisis, the low growth environment and tame inflation, the Federal Reserve has kept short-term interest rates at record lows for a decade.

Other bond yields have fallen as well: The 10-year Treasury was routinely in the 5 percent to 6 percent range or higher in the 1990s, a period of strong economic and productivity growth.

In the last few years it has ranged between 2 percent and 3 percent.

Underestimating the likely jump in Treasury yields would have an immediate impact on Trump’s bottom line, said Marc Goldwein, senior policy director at the Center for a Responsible Federal Budget. Over a decade, a 1 percentage point miss would add roughly a trillion dollars to the federal debt, he said.

It would also change the country’s financial dynamics as firms and households adjust from a world of nearly free money, to one where borrowing exacts a steeper penalty.

The rates baked into Trump’s budget “seem low given the growth rate, and there are implications,” Goldwein said. “It could partially offset your 3 percent growth” if consumers and businesses reduce borrowing, he said.

(To view a graphic on 'Trump banks on growth, not higher rates' click here)

Reporting by Howard Schneider; Editing by Cynthia Osterman

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