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Increasing Interest Rates to Reduce Inflation.  What Happens Next? Thumbnail

Increasing Interest Rates to Reduce Inflation. What Happens Next?

“One should not carry out an action if they are unwilling to handle the consequences.”

-Ancient Proverb

The colloquial interpretation of the above proverb is “do the crime, do the time”.  An apt rephrasing could be “if you borrow the money, pay it back”.  The U.S. Federal Government has been borrowing for decades to fund all manner of serious government programs and politicians’ pet projects, with a major acceleration over the past decade.  U.S. Government debt now exceeds $30 trillion. That’s over $90 thousand per capita and costs more than a $1 billion per day to finance!  At 20% more than GDP, it is by far the highest in history, having exceeded GDP (and then by only a few percent) only once before, at the end of World War II.  Politicians of all stripes have borrowed recklessly, passing the buck (pun intended!) down to future generations.

This is, first of all, a dangerous experiment.  Other countries have rung up higher debt levels (relative to GDP) – Japan is an example.  But none of these countries has nearly as large an economy as the U.S. nor is their currency the global “reserve” currency.  We have no historical template for how this plays out if our debt grows to 150%, 200%, or more of GDP.  No one can seriously predict what will happen, but the potential negative scenarios far outnumber the positive ones!  There is also an issue of “fairness”; how just is it to spend well beyond your own means to support and pass the responsibility of repaying the debt to future generations?  Some will argue that we are passing along a better society or country to those generations as well, so it is not unfair, but we are nevertheless making that choice without their input and also constraining their future consumption choices by hamstringing their finances.

But getting back to the issue of repayment. We argued in this piece back in August 2016 (when the debt was “only” $19.5 trillion) that serious inflation was on the horizon because that was the only way to repay (or at least slow the growth of) the debt.  The alternatives, (1) growing our way out of it; or (2) defaulting; are impossible and unpalatable, respectively.  So, as the U.S. Government did between 1946 and 1981, when it “used” inflation to erode the value of the national debt by over 90%, it virtually must do the same again.  Inflation is effectively a “tax”, but one much more acceptable to the political class because they don’t have to vote on it and pay the consequences, which is also why they always blame inflation on “outside” forces like foreign wars, corporate greed, other countries’ gouging, supply-chain issues, etc.  We’ve seen these tropes hauled a lot recently.  The bottom line is that we are paying for this borrowing via inflation and future generations will be similarly “taxed”.  

We were clear in 2016 (and again in February 2019) that we had no idea of when the return of inflation would occur, but that it was imminent and certain. Well, here we are.  Again, we have no idea of the exact path of inflation going forward. However, a reasonable guess is that the current 8.5% rate will persist for a few months, maybe a bit longer (and maybe go a little higher), and then the Fed (which has already begun to raise short-term rates, including a 0.50% jump in Fed Funds on May 4) will get it “under control”, but not to the microscopic levels we have been accustomed to for the past 20 years.  It is then likely to remain above the 2% “target” for some time to at least allow for braking, if not actually reversing, the rise in debt to GDP levels.  We did the crime, we have to do the time!

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