Could This Interest Rate Cliff-Edge Cripple the U.S. Economy?

Could This Interest Rate Cliff-Edge Cripple the U.S. Economy?

Why you should care

Because easing out of quantitative easing may not be so easy.

After a strong January, the stock market got a case of February jitters when newly nervous investors began to wonder what a hike in interest rates could mean for future interest rate policies at the Federal Reserve, especially under the new leadership of President Trump’s nominee, Jerome Powell.

Not that the bump came as a surprise. After all, the world’s most influential central bank has been saying for years that it will remove the economic stimulus measures known as quantitative easing that have been in place since the 2008 financial crisis and hike rates as soon as its inflation targets of 2 percent are satisfied.

It now appears that inflation is on the move — 2.2 percent in February, according to the producer price index. The market brushed aside the news, but some anxious investors are wondering what happens if inflation starts to gallop ahead of the target? Central banks have worked for years to stoke inflation: What if they finally get more than they bargained for?

Out-of-control inflation is a gray rhino — a high-impact, negative occurrence that is rationalized until it is too late. The government’s response, though, could lead to a true black swan: a low-frequency, high-impact event that no one sees coming. And it could be that the Fed will be forced to jack up interest rates at a speed not seen since the 1980s. Even the perception of such actions could spook bond markets.

If rising interest rates rattle bond markets and pop yields on 10-year U.S. Treasury notes north of 7 percent, annual interest payments would exceed $1 trillion.

That scenario would make interest payments the federal government’s largest single expenditure — bigger than Social Security ($916 billion in 2016), defense ($605 billion) or Medicare ($594 billion).

What’s more, if the Fed and the European Central Bank respond to runaway inflation with accelerated large interest rate increases and the expedited removal of monetary stimulus, it could turn current all-time-high markets to years of lows in the space of a few months.

At the very least, monster interest payments would cause massive disruptions in global financial markets …

It was back in 1996 when the yield on the 10-year U.S. Treasury note last traded at these levels, and the sky did not fall. Moreover, the economy in the ’90s is generally regarded as emblematic of the “good times.” So why would a sudden return to these levels be such cause for concern?

For starters, the national debt is now more than four times as large as it was in 1996 — $20 trillion and growing, compared to just under $5 trillion. While some of the national debt is essentially made up of IOUs that the government owes itself, the vast majority consists of debt on which the federal government must pay interest. That means as interest rates rise, the federal government must pay more to service the debt. With more debt than ever before, the associated costs with higher interest rates are astronomical.

At the very least, monster interest payments would cause massive disruptions in global financial markets, exacerbated by the lofty valuations markets have achieved in the past several years.

But a more radical black swan may glide into view. As high interest rates paralyze the U.S. government and corporations by exponentially increasing debt-servicing costs, the U.S. Treasury may see no other option than to relieve the Federal Reserve of its rate-setting authority, take over that function itself and enact a 2.5 percent cap on 10-year U.S. Treasury notes to release fiscal pressure. Such a move would mean an end to more than a century of independent Federal Reserve policy and bring a new paradigm to the world financial order. The unintended consequences of price-of-money controls could cause the American — and global — monetary systems to dissolve.

It may seem outlandish — but then black swans are necessarily preceded by extreme manifestations of unexpected events. The end of cheap money from 10 years of monetary stimulus coupled with the largest national debt in history and a political environment in Washington where the unexpected has become commonplace mean it could happen in 2018.

Jeffrey Moore II is a senior analyst at Global Risk Insights.

By Jeffrey Moore II

Political and geopolitical publisher Global Risk Insights sets off with OZY to explore our volatile world.


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