This is an excerpt from Counter-Intuitive Inflation. We’ll be posting sections over the first two weeks of October.

How Rate Hikes Can Be Inflationary and Why It’s Different This Time:

What we’ve shown above is how overspending leads to inflation, and that the US government has no plans to curtail spending. For now, that includes military spending. That leaves interest expense as the remaining significant part of the budget. There’s a trend here as well:

Federal government interest payments are already at $1 trillion/year.

These expenses have risen by approximately $600 billion dollars in the past decade. The only reason the increase has been so small is because we’ve had near-zero rates for most of that time period.

Keeping the 10-year below 2% for years isn’t sustainable.

As I write this, the yield on the 10-year Treasury has just exceeded 4.5%. With interest expense of $1 trillion on total debt of $33 trillion, we have a current cost of debt of about 3% for the Federal government. As more of the low-cost debt issued in the last decade matures, the new Treasury auctions will be at the new higher rate. While Powell hammers home the “higher for longer” message, the annual increase in cost for the new debt will start to approach $500 billion. (Note:  While this piece was in edit, the 10-year treasury yield rose from 4.3% to above 4.5%.) The government plans to overspend by an additional $2 trillion in the next 12 months which at 4.5% would add another $90 billion in interest expense. This means that in the next year or two, annual interest expense will be heading for somewhere in the $1.6 trillion to $2.0 trillion range.

Again, there are no plans to cut spending. Congress, the Treasury, and the Federal Reserve will conspire to print another trillion dollars of currency each year to cover incremental interest cost. As discussed above, large scale currency creation causes inflation whether we’re talking about an increase in the money supply or in prices for the consumer. That subsequent additional inflation will put pressure on the Federal Reserve to raise interest rates which in turn, increases interest expense. Wash, rinse, and repeat for a few cycles and you can see why it’s called a debt death spiral. This is the US version of what DKI has been warning about in Japan for the last year. If you’re starting to think this is a little like a Ponzi scheme, you’re close. The reality is it’s exactly like a Ponzi scheme.

The reason it’s different this time is the amount of government debt has ballooned out of control. In the past, debt levels were low enough that the Fed could fight inflation without causing the budget deficit to explode. The other reason it’s different this time is the US has never had this level of excessive spending during (relative) peacetime and when the economy wasn’t in a horrible recession. Congress is engaging in massive stimulus spending at a time when we don’t need it, have too much debt, and a terrible budget problem.

Trying to get inflation under control when debt is under $1T is different than when it’s $33T.

The market has been conditioned to think rates of zero are normal and appropriate. I’ve seen constant wailing for the last year and a half that the Fed has over-tightened interest rates and is destroying the economy. The Federal Reserve deserves plenty of blame for their part in our current and future fiscal problems, but I don’t agree that they’ve been too hawkish. First, the 10-year is currently at 4.5%. I love this chart because, while a bit dated, it gives a very long-term view of where interest rates have been:

Chart from Sevens Report Research

It’s the ultra-low rates of the last decade and a half that have been the anomaly. There’s nothing wrong with a fed funds rate between 5.0% and 5.5% and a 10-year that’s still below 5%. Also, inflation is still a problem. Real interest rates (the fed funds rate less inflation) is below 2%. So, after the loss of purchasing power, cash deposits are still earning under 2%.

The Fed was too loose with monetary policy previously. That doesn’t make them too tight now. With the increase in M2 and debt, rates should be above the long-term average.

I point this out because we’re going to take on an additional $4 trillion of debt between the summer debt ceiling agreement and the next election in 2024. Add to that the extra interest expense discussed above, and we’re facing a massive amount of additional currency creation. The result will be more inflation. Powell is on a treadmill where the faster he runs, the faster the treadmill moves beneath him.

 

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