What If All Debt Was Tied to the Fed Funds Rate?

This is a thought experiment, so take it with a grain of salt.


Click to enlarge.

Here is the explanation of the "what if" chart.

The chart shows what the interest payments on the real total credit market debt owed per capita (February 2012 dollars) would be *if* the interest rate on all of that debt was equal to the fed funds rate. Anyone with a credit card knows that's not the case, but bear with me.

We seem to run into serious problems when the total of this "what if" experiment exceeds $8,000 per capita (adjusted for inflation). Note the recession bars. And for what it is worth, $8,000 per capita does sound painful.

If it is our intention to continuously grow our inflation adjusted debt (as Japan has done) and simultaneously stay below the seemingly dangerous $8,000 per capita threshold, then at least one of the following two things must happen over the long-term.

1. We must grow our population.
2. We must continuously reduce interest rates.

What would it take to hit the $8,000 threshold right now you might ask? We currently have $173,000 total credit market debt owed per capita. That would mean that a fed funds rate of 4.6% would seemingly cause serious problems ($173,000 x 4.6% = $8,000).

In 1980, we had an inflation adjusted $55,000 total credit market debt owed per capita. That meant that we could handle a fed funds rate of 14.5% before things broke ($55,000 x 14.5% = $8,000).

The interest rate that it takes to break the economy is exponentially decaying. I believe that with every fiber of my being.

It took a 15% interest rate to break the economy in the 1980s. Thanks to the miracle of modern financial leverage it probably only takes 5% now. And should we stay on Japan's path, I suspect that it may only take 1% in one more decade.

So what's my point? If you are waiting on the sidelines for interest rates to rise to the stratosphere and make you bloody rich like they did for previous generations, then good luck on that theory. That's not to say that real yields might not pop up again in the short-term. The deflationary event a few years ago did just that. It could happen again. I find it hard to believe that investors will be rewarded by burying paper dollars in their backyards over the long run though.

The following chart shows the historical 10-year treasury yield minus the federal funds rate. The median is gap is 1.07%. As of yesterday, the gap was 2.12%. I'm thinking that Bernanke would really like to see that 10-year yield come down to meet him halfway. That's assuming he wants us all to learn Japanese of course. Will he succeed? You tell me and we'll both know.



This is not investment advice. It is just a thought experiment based loosely on my long standing belief that real yields would die. That was before I had the Mundell–Tobin effect epiphany which sealed the deal.

Source Data:
St. Louis Fed: Custom Chart #1
St. Louis Fed: Custom Chart #2