The Homa Files

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?

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Here’s my take…

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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.

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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?

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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.

Hmmm.

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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

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Takeaway

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.

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This entry was posted on December 17, 2015 at 6:49 am and is filed under Federal Reserve, Interest rates, Law of big numbers, Numbers - big & small. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.