The Federal Reserve has embraced a “hawkish” policy over the past year to tame inflation that has reached well above its target.
Inflation reached its peak this summer at 9.1%, while the target inflation rate is 2%. Therefore, the Fed has been raising interest rates at an unprecedented, breakneck speed often in 75 basis point increments.
There are several high levels reasons for the unique economic situation we are in. Since the Great Recession in 2008, we have undergone massive a expansionary monetary policy known as “quantitative easing” where interest rates are lowered to spur economic activity.
This was further exacerbated in March 2020 when the economy was brought to a standstill due to COVID. Interest rates were already very low at this point, so the Fed’s only option was to lower them even further to zero.
This led to an economy during the pandemic that was hot with demand, but had severely disrupted supply chains. Alongside this, there is the war in Ukraine, massive government stimulus, and a war on fossil fuels which have contributed to price increases.
As we’ve seen, inflation subsequently became a big problem and now interest rates are between 3.75% and 4.25%. Some members of the Federal Reserve forecast that rates may need to reach as high as 5.5% to tame inflation before they come back down.
The current federal funds rate has translated to high borrowing costs across the market. The Prime Rate, the rate that banks charge their customers with the best credit, is at 7%. Analysis indicates this is “unsustainable” due to current levels of debt.
Overall debt in the U.S. is roughly $93 trillion dollars, made up of both private sector and government borrowing. Borrowing has been cheap thanks to low interest rates, so in the past couple years leverage has increased substantially.
When comparing debt to U.S. gross domestic product, we see that debt is roughly 3.6 times higher than GDP. This implies that servicing this debt will be very strenuous if interest rates remain at high levels.
According to Seeking Alpha:
“The Bank Prime Rate at 7.00% today with $93.05 Trillion in debt is about $6.51 Trillion. With a GDP estimated to be about $26.02 Trillion in the 4th quarter of 2022, that makes the $6.51 Trillion debt service at about 25% of GDP per my exercise.”
Furthermore, JPMorgan forecasted in early 2021 the effect of high interest rates on federal debt, which was over 100% of GDP at the time:
“If rates were to rise and the average interest rate paid were to rise to 3%, rather than the average of 1.3% forecast under current conditions, the net interest payments as a share of GDP would rise to 3.2%. This is significant because net interest payments as a share of GDP peaked in 1991 at 3.2%, which forced President George H.W. Bush to renege on his promise of no new taxes. While this may not be the absolute breaking point, it could be deemed as a point of fiscal stress by historical standards.”
For perspective, the latest readings on the 10-year treasury yield are 3.67% with the long term average at 4.26%.
The high cost of servicing our large amount of debt is unsustainable and interest rates must come down somehow.
Some are hopeful about the prospect of a “soft landing” engineered by the Fed, since inflation appeared to have cooled slightly in October.
However, many economists think we are headed for a recession due to persistent inflation that is well above the target that will require continual rate hikes.
Regardless, something will have to give and provide a deflationary impact.
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