The Federal Reserve plans to raise interest rate as many as three times in 2022. This is in response to an economy that is showing signs of overheating, with inflation at its highest level in decades and an unemployment rate of 3.9 percent, a 22-month low. Is their decision prudent? More critically, are there unintended consequences of this move?
Savers will welcome higher short-term interest rates, as they have seen savings accounts and certificates of deposit rates barely above zero percent. However, with measured interest rate hikes, it will take months or years before savers see any meaningful results in their pocketbooks. Moreover, with inflation eating away at their savings, their buying power for goods and services will continue to erode.
On the loan side, commercial and home loan mortgage rates will climb, placing headwinds on economic growth to sufficiently cool inflation while attempting to keep the economy growing and employment steady. Federal Reserve chairmen have managed this delicate balancing act for decades.
With the midterm elections fast approaching, Democrats in the House and Senate should be concerned that an economic slowdown or an ill-timed market correction prior to November could squelch any hopes of holding their majority status.
The greatest impact that higher interest rates will have is on the largest borrower in the world — the United States government. The United States national debt is nearly 30 trillion dollars, which it finances through Treasury bills, notes and bonds. The public holds 80 percent of this debt, which requires direct interest payments, rather than ledger transfers on the Treasury books.
The fiscal year 2021 United States budget included over $562 billion spent paying interest on the federal debt. Almost every federal department’s annual budget is less than this amount.
To put these amounts in perspective, the cumulative net worth of the five wealthiest people in the nation in 2021 (Jeff Bezos, Elon Musk, Bill Gates, Mark Zuckerberg and Warren Buffet) was $465 billion. So, the interest paid to the public in 2021 is more than these five people’s net worth, and the publicly held part of the national debt is over 50 times larger than their aggregate net worth.
What makes this situation most disturbing is that the current debt interest level is during a period of historically low-interest rates. Any measurable increase in short, medium or long-term interest rates can add hundreds of billions of dollars of interest to the federal budget. Given that the federal government has rarely operated with a balanced budget over the past 60 years, added interest costs will continue to accrue and compound, costing future generations an erosion in their standard of living.
It does not require advanced economics to see that higher interest rates may be an effective tool to suppress inflation, but with soaring national debt they are an anathema to the economic stability of the nation. Unbalanced budgets, growing debt and higher interest rates mean that every government program becomes at risk, as the percentage of the federal budget consumed by debt interest payments grows. It also places limitations on future investments needed to address pressing and sometimes unexpected issues. The COVID-19 pandemic represents one such perturbation that has required massive infusion of capital.
Are there any palatable alternatives?
Inflation devalues debt. It withers the buying power of currency, while hard assets like precious metals and real estate maintain their value. However, value is of itself a perception.
If inflation grows untethered, it will erode the wealth of the nation, a means to redistribute wealth and level the socio-economic playing field. With numerous countries tied to the American economy, the global economic risks are significant and the consequences would be catastrophic.
To reduce the national debt responsibly demands bipartisan cooperation, something that is woefully absent in Congress and in state legislative bodies around the nation.
It is astounding how elected officials in the federal government continue to ignore the national debt, the 800-pound fiscal gorilla in the room. The reason is simple: Politicians avoid addressing the national debt because it would do nothing to help them retain their power and gain reelection. In fact, addressing the national debt could result in pet projects going unfunded, which would threaten their reelection.
Without widespread and substantive bipartisan cooperation, the national debt will continue to grow untethered, with higher interest rates adding to the nation’s fiscal misery. In such an environment, the price paid by every American is an erosion in our standard of living, creating wider schisms between those that have and those that do not.
So, when the Federal Reserve moves to raise interest rates, the flood gate of economic risk will open. With such risk, the price that our nation will pay is tremendous. If there is any time for bipartisan cooperation, that time is now.
Sheldon H. Jacobson, Ph.D., is a founder professor of Computer Science at the University of Illinois at Urbana-Champaign. He applies his expertise in data-driven risk-based decision-making to evaluate and inform public policy.