There is a lot of talk currently by Janet Yellen and other Fed officials about interest rates and the Fed’s balance sheet. There is always debate going on in the financial community about where the Fed will take interest rates and how fast.
Right now, the Fed controls the overnight lending rate for banks (the federal funds rate) by paying interest on bank reserves. It is not controlled (as in the past) by increasing or decreasing its balance sheet (the money supply).
Therefore, the Fed does not directly control interest rates. In fact, it is possible even the opposite will happen of what is expected. If the Fed continues to raise its target rate, most people are expecting market interest rates to rise. But if the Fed’s raising of its target rate coincides with a recession (whether or not it is the cause), then long-term interest rates will probably go down as investors seek safety out of stocks.
Now let’s forget about the Fed and look at what might happen if market interest rates were to rise significantly. Many libertarians and those of the Austrian school have been stating that there is a bond bubble. The problem is that some of these people have been saying it for a rather long time. Of course, anyone who knows Austrian economics and the study of human action should know that it is impossible to predict the market with certainty, especially the timing. This would require predicting how billions of people are going to act.
We probably are in a bond bubble, but we don’t really know when it will finally collapse. Things can go on for a lot longer than what seems possible. After all, Social Security is still humming along.
It is common to read (amongst both libertarians and non-libertarians) that if interest rates go up by a certain amount, then it is going to lead to payments on the national debt going up by a certain amount. This is all true.
The problem is that many analysts say this as if it would be a dire situation. You may hear someone say something such as, “If interest rates go up to this level, then the federal government will owe $500 billion per year in interest payments, and then we will be in big trouble.”
My question is, “Who will be in big trouble?”
I think that higher interest rates would ultimately be a blessing for the average American. Sure, just as with a recession, there will be aspects that will be painful. But you need this short-term pain in order to straighten things out onto a path of greater prosperity.
The biggest problem we have economically is the massive level of government spending. I understand this is debatable. The regulations we live under are horrendous and stifle business to a great degree. One could also say that the Fed is the biggest problem, but I think this really just goes hand-in-hand with government spending. It is the Fed’s ability to create money and buy assets that allows the great level of deficit spending by the federal government.
Virtually every dollar spent by the U.S. government is a misallocation of resources. Of course, some spending is far more damaging than other spending. I would rather see someone get their Social Security check than to see more money go into bombs and tanks in order to go to war.
The federal government is currently spending in the neighborhood of $4 trillion per year. The bulk of this spending (about 80%) is on military (called “defense”), Social Security, Medicare, Medicaid, and interest on the debt.
Let’s say, hypothetically, that the national debt grew bigger and interest rates spiked up so high that the annual interest payments on the debt amounted to $2 trillion, which is half of the current budget. Meanwhile, as similar to the 1970s, the dollar is quickly losing its status as a reliable currency.
Therefore, the Fed has to pull back and allow its target rate to rise even further, as similar to the late 1970s and early 1980s.
All of a sudden, Congress is essentially forced to cut spending. Actually, even if it doesn’t have to cut overall spending, it has to divert nearly $2 trillion to interest payments that was previously being spent on other things.
If Congress does not drastically cut Medicare and Social Security, then it will be cutting most of the military and most of the discretionary items.
Where does this $2 trillion of interest payments go? It goes to investors. That includes going to foreign central banks such as Japan and China. It includes private investors. It includes private pensions and 401k plans.
I would much rather see $2 trillion per year diverted to investors than continued to be spent and misallocated by the bureaucrats in Washington DC.
While virtually all government spending is a misallocation of resources, some misallocations are worse than others. I would rather see money going into private hands where it can be saved, spent, or reinvested, rather than being spent on government programs that take away our liberty.
In addition, the higher interest rates would likely lead to overall spending being reduced. This is what we so desperately need.
After the fall of 2008, many state and local governments were forced to cut back, especially with falling tax revenues from property taxes. Meanwhile, because of the Fed, the federal government’s spending exploded. That was the exact opposite of what we needed.
One of the main reasons that the American middle class is struggling so much is because government is simply spending too much of our money. It doesn’t matter if it is done through taxation or through deficit financing. All of this spending is misallocating resources. This money is going towards resources that are not in the highest consumer demand.
Therefore, I say we should hope for higher interest rates sooner rather than later. It will be a painful time either way. Right now is a painful time as many Americans struggle to save money and pay their bills. They are in need of a correction. They need reduced government spending, especially at the federal level. This can be brought about by significantly higher market interest rates.