Interest Rates, Inflation, Wishful Thinking, and Unintended Consequences

 

The Federal Reserve's statutory mandate, as described in the 1977 amendment to the Federal Reserve Act, is to promote maximum employment and stable prices. These goals are commonly referred to as the dual mandate.

However, this dual mandate of maximum employment and stable prices can often be in conflict. A strong job market leads to higher wages, which can eventually feed into consumer prices, according to the Phillips Curve. In essence, the same economic growth that creates jobs can also spark inflation. Low inflation generally results in higher unemployment and vice versa.

When inflation is too high, the Federal Reserve typically raises interest rates to slow the economy and bring inflation down. When inflation is too low, the Federal Reserve typically lowers interest rates to stimulate the economy and move inflation higher.

Right now, we do not have stable prices. Yet, continued Fed rate hikes (aka, tightening) in an effort to control prices could ultimately lead to lower employment and even layoffs. This is the very tricky path the Fed is navigating. A lot is riding on it.

The Fed has a longstanding goal of maintaining a 2 percent rate of inflation. In the early part of the 21st Century, inflation consistently ran a little hotter than that objective. Then came the Great Recession, which followed the financial crisis in the fall of 2008. That ushered in an extended period of very low inflation, generally falling below the Fed's 2 percent goal. 

2000 - 3.4%

2001 - 2.8%

2002 - 1.6%

2003 - 2.3%

2004 - 2.7%

2005 - 3.4%

2006 - 3.2%

2007 - 2.8%

2008 - 3.8%

2009 - -0.4% (Great Recession)

2010 - 1.6%

2011 - 3.2%

2012 - 2.1%

2013 - 1.5%

2014 - 1.6%

2015 - 0.1%

2016 - 1.3%

2017 - 2.1%

2018 - 2.4%

2019 - 1.8%

2020 - 1.2%

2021 - 4.7%

2022 - 8.0%

2023 - 4.1%

*Data Source: U.S. Bureau of Labor Statistics

From 2009 to 2020, a span of 12 years, the inflation rate failed to reach the Fed’s 2 percent goal. Americans got used to historically low inflation. Then came the global pandemic, disrupted supply chains, and rampant corporate greed. Prices had been relatively stable for over a decade, so corporations took advantage of a global crisis to jack up prices, quite radically. Corporate profits as a share of national income have skyrocketed by 29% since the start of the pandemic, according to the St. Louis Fed.

The longer term trend is even more pronounced. In 2000, corporations in the U.S. made profits of $786 billion. By 2022, corporate profits reached about $3.5 trillion. That’s an increase of more than 400 percent.

It’s also worth noting that inflation is not a US phenomena; it's running high in all the OECD countries. Among G20 countries, the US inflation rate was the eighth lowest last year.

Some less informed Americans think the US President can control inflation. Wrong. The Federal Reserves tries to control inflation, but it often fails to meet its own stated objective. The Fed attempts to control inflation by manipulating Interest rates. In theory at least, when interest rates are lowered it stimulates borrowing and, thereby, economic activity. So, prices generally rise. Conversely, when interest rates are increased it deters borrowing, slowing economic activity. Yet, even as the Fed has continually raised rates, economic growth and inflation have continued unabated.

From 2022 to 2023, the Fed increased the funds rate 11 times, bringing it from a historic low of 0.08% to the current 5.33%, the highest the rate has been in over 20 years. Despite these repeated rate hikes, inflation still rose 8 percent in 2022 and another 4.1 percent in 2023. The US economy is a broad-based juggernaut and attempting to subdue it has proven to be like trying to tame a wild bull.

The funds rate is the interest rate at which all others are set, even those of the federal government, which must issue bonds, bills and notes to finance its operations. Rising interest rates are a nightmare for the U.S. government. The federal government will spend $892 billion in the current fiscal year on interest payments — more than it has earmarked for defense. Next year, interest payments will top $1 trillion, according to the Congressional Budget Office, Congress’s fiscal watchdog.

While still historically low, the current funds rate is an unsustainable figure for our deeply indebted federal government. This is why I believe there will be heavy pressure on the Fed to lower interest rates before borrowing costs become too cumbersome for Washington. Inflation will cripple average Americans, but it will inflate away some of the national debt, making interest payments more manageable. No matter how much pain inflation causes Americans, there will be heavy pressure on the Fed to cut the funds rate.

This is the course that the Fed will navigate. Cutting rates to make debt payments more manageable will likely lead to continually elevated inflation, which over the long run will likely lead to lower employment, perhaps even layoffs. Ultimately, it could lead us right into a recession. They always come, it’s just difficult to predicate exactly when.

Since the end of World War II, the U.S has suffered through 12 recessions, or an average of one every 6.5 years. The last economic expansion, starting at the end of the Great Recession, lasted 128 months. By that measure, we were overdue for an economic retraction when the Pandemic Recession hit. 

For those most concerned about inflation, the good news is that recessions are, by definition, deflationary.

Millions of Americans are wishing for lower inflation. Corporate leaders are wishing for lower interest rates. Congress may soon start begging for lower rates to deal with our insurmountable debt. The next president will likely pressure the Fed to lower the funds rate for the same reason.

All of them should be warned: Be careful what you wish for. There are always unintended consequences.

Our Debt is Slowly Crushing Us

If you’re not highly concerned about our nation's debt problem, you should be.

The Great Recession and 2008 financial crisis were sparked by an excess of debt in an overly connected global financial system.

Today, the total amount of debt is even greater at the federal, corporate and consumer levels, while state and local debt is enough to be catastrophic in the next recession. In essence, the solution to the debt crisis was to create even more debt.

Next time will be different, because it will be worse.

This most obvious concern is the national debt, which has surpassed $21 trillion. This whopping debt is serviced by borrowing even more money, creating a sort of black hole of debt that can never be escaped.

According to a Congressional Budget Office report released this month, trillion dollar deficits are now the norm. Congress recently voted to both reduce revenues by cutting taxes and to increase spending. Those can only be described as acts of insanity.

As the debt has steadily grown, an annual deficit of 3 percent (which was long viewed as a stable) results in ever-expanding debt payments. For example, 3 percent of a $100 billion deficit is $3 billion. However, 3 percent of a $1 trillion deficit is $30 billion. As a result, the growth in federal debt has become exponential.

People often measure the national debt in relation to the size of the economy — the so-called debt-to-GDP ratio. However, the government doesn’t service its debt with the entire economy; it services it with tax collections, which are now smaller and actually adding to the debt.

Yet, our troubles aren’t confined to the federal government.

At the end of 2017, the 50 US states had a cumulative debt of $1.176 trillion. When local debt is added, the figure leaps to more than $3 trillion. Most states have constitutional requirements stipulating that they maintain balanced budgets, yet none of them manage to do that.

Even the most financiallly healthy states face substantial long-term challenges related to their pension and healthcare benefits systems.

Additionally, total corporate debt has reached an unprecedented level and is currently at three-and-a-half times GDP. Even a moderate drop in the value of corporate bonds would result in wealth losses equivalent to a large fraction of GDP. For example, a 10 percent decline in the value of corporate debt would wipe out an amount of wealth equal to 35 percent of GDP. That would mean absolutely massive losses for bond holders, such as pensions and 401ks. That should make you queasy.

The chart below shows the additional economic output (GDP) generated by each additional dollar of business debt in the US. As you can see, debt has become steadily less stimulative over the last several decades. Despite low interest rates and a massive debt binge, the stimulative affect of debt is back down where it was during the lows of the Great Recession. That’s troubling.



Furthermore, total household debt rose to an all-time high of $13.15 trillion at year-end 2017, according to the Federal Reserve Bank of New York. It was fifth consecutive year of annual household debt growth, with increases in the mortgage, student, auto and credit card categories.

Our economy is addicted to debt for growth; it can't function without it. But, like any addict, our addiction is slowly killing us. We need more and more of the drug (debt) to get a continually weakening effect. Without our government’s deficit spending, our economy would likely be in a depression.

This policy of debt-induced economic expansion is baked into the cake; it is the very essence of our economic system. However, spending a dollar to get anything less than a dollar of return is not productive.

As Chris Martenson at Peak Prosperity notes, debt has been growing twice as fast as GDP for nearly five decades. That’s not sustainable. Debt expansion only works if it is exceeded by GDP growth.



Eventually, this will end very badly and it will be terribly disruptive to our economy, our national security and our way of life. There is no cure or recourse, other than a massive deflation.

Yet, that’s exactly what our financial masters at the Fed and on Wall St. are desperately trying to avoid… until they no longer can.

Federal Budget Crisis Speeding Ahead Like Runway Train

The national debt now exceeds $21 trillion. Consequently, the interest payments on that debt are rather massive.

Case in point, the Treasury Dept. this week had to borrow nearly $300 billion, the most for any single week since the financial crisis in 2008. It’s worth noting that as recently at 2007, the federal deficit was just $161 billion. Consider that: the government is now borrowing nearly twice that amount in just one week.

Federal revenues are declining due to the Republican tax bill. All by itself, aside from any new spending, the law will add $2.3 trillion to the debt over the next 10 years, according to the Treasury Dept. Of course, the Trump Administration argues that the cuts will spur the economy and thereby pay for themselves. That’s a spurious argument since it has been tried repeatedly and has never worked, except in the short term.

Despite this, spending goes on, unabated.

Just last week, the House and Senate passed a massive 2,232-page, $1.3 trillion spending bill that significantly increased federal spending. The bill boosts domestic spending by $128 billion and defense spending by $160 billion over two years.

Where are the Tea Party Republicans when you need them? Congress and the White House are controlled by the GOP. Remember when they used to call themselves "fiscal conservatives" and "fiscally responsible," and some people took them seriously?

So, the government is simultaneously reducing revenues while increasing spending. It is a terribly reckless policy.

Remember, this is being done willfully, as opposed to during an economic crisis, when the government can’t control the collapse in revenue. The prescription in those times, in the absence of consumer and corporate/business spending, is typically a temporary increase in federal spending to uphold the economy.

It’s as if the government is trying to hasten an economic and fiscal crisis.

This all comes at a time when Donald Trump is threatening a trade war with China, which holds $1.17 trillion of US debt, In fact, China owns of more Treasury bonds than any other foreign country.

Meanwhile, the Federal Reserve is finally ending the bond-buying program it initiated during the financial crisis. Yet, somebody has to finance America’s deficit spending, which is only increasing. The United States ran a $215 billion deficit in February, the biggest in six years.

The federal government is on track to borrow nearly $1 trillion this fiscal year, the highest amount of borrowing in six years and almost double what it borrowed in fiscal 2017.

According to the Congressional Budget Office, trillion dollar deficits are now the norm and stretch into the future as far as the eye can see.

The Committee for a Responsible Federal Budget, a fiscal watchdog group, recently warned that interest payments on US debt could quadruple to $1.05 trillion by 2028 if the current course is maintained.

This is like one of those Hollywood thrillers, in which a speeding train is on course for a massive collision. All of the rail and public safety officials know it, and everyone is rushing to avert a tragedy.

However, our current predicament isn’t a fictionalized Hollywood tale and there isn’t a hero who will save us in the end. This speeding fiscal train is heading for a cataclysmic disaster and, just like the Hollywood version, all the officials know it.

The difference is that this inept, selfish group of officials (Congress and the White House) is doing nothing to stop it. To the contrary, they’re speeding up the train.