US debt spiral forces Fed intervention despite rising inflation risks

This administration has been given a financial mess and with it a difficult road. Our debt/GDP is around 120%, an emerging market level in crisis, held together by the importance and relative stability of our economy and financial markets, as well as the fact that the US dollar remains an important reserve currency and trading currency.

Our government continues to struggle with massive deficits, the kind you see during a recession or war, not during a time when GDP is expanding. And we are now at a point where the interest expenses on our national debt exceed our defense expenditures. As stated in the Ferguson Act, named after historian Niall Ferguson, “any great power that spends more on debt payments than on defense risks ceasing to be a great power.”

President Donald Trump is right to be concerned about interest rates, given that higher interest rates lead to higher debt servicing costs and that the amount of debt to be financed has increased this year, as well as the fact that we have trillions of dollars of debt to be refinanced.

But there is no free lunch.

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While the Fed is lowering target interest rates, this is more directly related to interest rates at the short end of the yield curve (i.e. short-term Treasuries). The market controls the long end of the curve (i.e., longer-dated Treasuries such as 10, 20, and 30-year maturities). And we’ve seen those returns remain stubbornly high.

Ultimately, some form of yield curve control (measures that bring in and push down long-term bond yields) will probably be needed. If we continue to see our interest expenses rise, this will lead to a larger deficit. This means more debt financing, which will push up yields, make interest expensive again and create a debt spiral until U.S. and global bond markets are thrown into turmoil.

But Fed intervention comes at a cost, as we see with Fed intervention and government overspending. The price paid will likely continue to inflate assets (on a nominal basis). While we need this because a decline in the value of stocks and homes over a period of time will likely lead directly and indirectly to a reduction in government revenues (i.e. tax revenue), it also has the same effect of increasing budget deficits and exploding the cost of debt. This again means that some precautions will be taken.

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This is also why it doesn’t matter much whether Fed Chairman Kevin Warsh is positioned as a hawk (favoring tighter Fed policy) and dovish (favoring looser monetary policy). Our financial situation and basic math will force him and the Fed to intervene in the markets and lower interest rates one way or another.

The price of keeping our financial institution together will likely be inflation. This will continue to erode the purchasing power of the US dollar and create a wider gap between the rich and the middle class in America.

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However, intervention is only a temporary solution. It saves time but doesn’t solve the problem.

The fundamental problem will not go away unless government spending is reduced in all categories, not just by reducing interest expenses, or unless growth is achieved large enough to eliminate the deficit in both scenarios. We are only stopped for a short time and then we are in the same situation again.

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Our government continues to struggle with massive deficits, the kind you see during a recession or war, not during a time when GDP is expanding.

And if you’re familiar with Congress, there doesn’t seem to be any political will in any of the major political parties to spend within a real budget.

So yes, interest rates are an issue, as are government spending. Warsh will have to help whether he wants to or not, and we’ll all pay the price.

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