Runaway National Debt Could Push Interest Rates Higher: Fed's Schmid

Kansas City Fed President Jeffrey Schmid said Tuesday that the future path of interest rates remains unclear, with uncertainty surrounding how much further they could fall or where they might stabilize, particularly given factors like productivity, demographics and the rising national debt.

Speaking at the Omaha Chamber of Commerce Economic Outlook Forum, Schmid noted that while the Federal Reserve is cutting rates as inflation cools, the longer-term direction of borrowing costs remains a puzzle.

According to the Fed official, the U.S. economy faces a tug-of-war between three powerful forces?productivity growth, demographics, and ballooning government debt. Each of these factors pulls interest rates in opposing directions, leaving uncertainty about where rates will land in the years ahead.

The Federal Open Market Committee (FOMC) reduced its benchmark interest rate by 75 basis points this year, with a quarter-point cut in November following a half-point reduction in September. These rate cuts, after a prolonged period of tight monetary policy, signal growing confidence that inflation is on track to return to the Fed's 2% target.

"While now is the time to begin dialing back the restrictiveness of monetary policy, it remains to be seen how much further interest rates will decline or where they might eventually settle," Schmid said during remarks delivered to the Omaha Chamber of Commerce.

Inflation cooling and better alignment in labor and product markets have supported the decision to lower rates. However, questions linger about how far rates will drop or whether cuts are a short-term necessity rather than a structural shift.

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Productivity Surge: AI Sparks Optimism

U.S. labor productivity has grown at an annualized 2.5% pace over the past 18 months?double the rate seen in the decade before the pandemic. This rebound stems partly from a cooling labor market, which has reduced turnover and improved worker-job matches.

AI is the big game-changer. "The massive investments being made suggest that the expected productivity gains from the technology must be enormous," Schmid said.

AI’s energy demand is also driving change. Over the past three years, U.S. electricity usage has grown 1.3% annually, more than double the pre-pandemic rate. States like Nebraska and Wyoming, hosting booming data centers, have seen electricity consumption surge. This increase reverses decades of declining electricity intensity (electricity per GDP unit).

However, Schmid cautioned that outdated energy infrastructure could become a bottleneck for growth without significant investment.

Aging Population: A Drag on Growth

Demographics present a less optimistic picture. U.S. workforce growth is nearly stagnant, with just 10 million new workers expected this century compared to 100 million since 1945. Globally, aging populations will depress investment demand and push interest rates lower.

China's population, for example, is expected to shrink by nearly 1 billion people by 2100.

Older populations also tend to save more, further depressing borrowing costs. According to Schmid, "Demographic trends are likely to put downward pressure on interest rates."

Rising Debt: Rates Face Upward Pressure

Government debt is rising fast and while demand for U.S. Treasury bonds once kept rates low, surging supply may now push them higher, Schmid warned.

"Large fiscal deficits will not be inflationary because the Fed will do its job," Schmid said. But that job could mean persistently higher rates to counterbalance government spending.

“Political authorities could very well prefer that deficits not lead to higher interest rates, but history has shown that following through on this impulse has often resulted in higher inflation,” he added.

The Balancing Act

Schmid summed up the tug-of-war: "Faster productivity growth could lead to high interest rates, demographics point to low rates, and debt suggests high rates with slow growth."

The final outcome, he said, depends on which force dominates in the years ahead.

“As an optimist, my hope is that productivity growth can outrun both demographics and debt,” he closed.

Market Reactions

Schmid’s remarks on Tuesday largely focused on long-term factors shaping interest rates, leaving market expectations for the Federal Reserve’s December meeting unchanged.

Fed funds futures currently indicate a 59% probability of a 25-basis-point rate cut at the Fed's Dec. 18 meeting, according to the CME FedWatch Tool.

On Tuesday, Treasury yields moved lower. The 10-year yield fell 4 basis points to 4.39%, reflecting improving investor demand in the bond market.

Equities also posted gains. The S&P 500, tracked by the SPDR S&P 500 ETF Trust , rose 0.3% on the day.

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Image created using artificial intelligence via Midjourney.