We should apologize upfront because this isn’t quite as exciting as the title suggests.
But wait! Before you click out, note that this is still interesting and at least worth a skim.
One of the obvious questions as rates begin to rise is this: what happens to government, corporate, and household finances?
That is, what do rising rates presage for the liabilities side of the balance sheet for different classes of debtors? Is this going to be some kind of debt service cost armageddon? And if so, what does that mean for government finances, capex, and consumption?
The short answer to the armageddon question is: “no”. But again, the details are interesting. Below, find excerpts from Goldman’s deep dive.
We begin with the impact of higher interest rates on public sector debt servicing costs. Over the last few years, total public debt has stabilized as a share of GDP, as shown in Exhibit 3, with slight increases in federal government debt offset by slight declines in state and local government debt.
To estimate the impact of rising interest rates on government debt servicing expenses, we insert our interest rate, primary deficit and macroeconomic projections into a simple model of public debt dynamics. As the left-hand chart of Exhibit 4 shows, our interest rate projections imply that the effective nominal interest rate on federal government debt should rise by a bit less than 1pp from 2016 to the end of 2020. This in turn implies that net interest outlays will rise by somewhat less than 4pp as a share of federal spending and by a bit less than 1pp as a share of GDP by 2020. We assume that state and local interest outlays rise proportionately. Overall, our expectation that interest rates will rise more than currently discounted by markets implies an only moderate drag on Treasury finances, at least over the next few years.
We turn next to the private sector, starting with the impact of rising rates on household balance sheets. The left-hand side of Exhibit 5 shows that households are substantial net lenders, with net interest bearing assets amounting to more than 100% of disposable income. This figure has held roughly steady in recent years; assets have risen gradually, while on the liabilities side a continued decline in mortgage debt has been partially offset by increases in student and auto loans. As a result of its position as a net lender, the household sector earns positive net income from interest-bearing assets, as shown on the right-hand side of Exhibit 5.
The right-hand side of Exhibit 6 shows the resulting impact on consumption growth from rising rates via these changes in household sector interest income and expense. The consumption impact is positive because the fact that households’ total interest-bearing assets exceed their total liabilities outweighs the smaller propensity to consume of lenders. As a reminder, we focus only on interest income effects here; as we previously showed, accounting for substitution effects as consumers delay consumption in response to higher interest rates would result in a negative net effect on consumption.
In contrast to the household sector, the non-financial business sector (including both corporate and non-corporate businesses) is a net borrower, as shown on the left-hand side of Exhibit 7. The business sector has substantial interest expense but relatively little interest income, as shown on the right-hand side of Exhibit 7.
To estimate the impact of higher interest rates on business net interest expense, we first follow the same procedure as described above for households to estimate the impact on the effective interest rates of the business sector’s assets and liabilities. We use the resulting estimates, shown on the left-hand side of Exhibit 8, to calculate the impact on the non-financial business sector’s cash flow. Finally, borrowing from earlier work, we estimate the impact on investment spending by assuming that investment rises by 30 cents for every $1 of additional cash flow. The ultimate effect on investment growth, shown on the right-hand side of Exhibit 8, is fairly modest.