Why the Fed has to raise interest rates

If raising interest rates hurts the US economy, why is the Fed dead set on continuing this policy? It has no choice.

It took the US government 193 years to accumulate its first trillion dollars of debt.

The current tally of federal debt stands at over $21 trillion. This year alone the US will add a 13-figure number to its IOUs. Trillion dollar debts are the new normal.

If that sounds bad, wait till you hear this…

The Federal Reserve is hiking interest rates, which makes it even harder for the US government to pay back its debt.

In fact, the Congressional Budget Office predicts that by the year 2028 the US will pay almost $1 trillion dollar per year… just in interest!

Madness.

Here’s a question: if raising interest rates hurts the US economy in such an obvious way, why is the Fed dead set on continuing this policy?

The short answer? The Fed doesn’t really have a choice.

Maxed-out credit card

US government spending is out of control.

In the past 10 years alone, a sum of $10 trillion has been charged to the national credit card.

The country’s Visa bill shows a balance deep in the red. $21.6 trillion, to be precise.

Washington, we have a problem. Says Strategic Intelligence editor Jim Rickards:

“A $21.6 trillion debt would be fine if the US had a $50 trillion economy. The debt-to-GDP ratio in that example would be about 40%.

“But the US doesn’t have a $50 trillion economy. It has about a $20 trillion economy, which means its debt is bigger than its economy.”

Public and private debts are different in that (most) governments can turn on the presses and print more money. Indebted households don’t have the luxury of creating more money out of thin air.

Still, if the US used all the money it earned in a single year just to pay off debt, it would still be in the red. That’s never good.

It’s why Jim has made the rather disconcerting observation that the United States is going broke.

Even though it’s piled on debt in the past decade, interest payments on this debt have been manageable. That’s because interest rates have been at rock bottom.

But now the Federal Reserve, the US central bank system, is determined to “normalise” rates.

Unless it’s got a really good reason not to (like clear signs that the economy is tanking), the Fed will increase rates by 0.25% every March, June, September and December until interest rates are back at 4%.

Why 4%? We’ll get to that in just a moment. First the implications of the Fed moving interest rates higher.

The Wall Street Journal explains:

“Interest rates are rising as inflation normalizes around the Federal Reserve’s 2% target.

“That and the sheer scale of debt being accumulated by the federal government has put the U.S. on a path of rising interest costs that in the years to come could crowd out other government spending priorities and rattle markets.”

Last year the US spent a grand total of $263 billion just on paying interest. That amounted to 6.6% of the government’s total spending.

Now the Congressional Budget Office, a federal agency that analyses the economy for the US Congress, foresees that the US government will spend $915 billion on interest by 2028…

In practice, this means that by 2023 interest spending will be higher than America’s defence budget.

By 2025, the US will spend more on interest than on “all non-defence discretionary programmes combined”, which include healthcare, education, scientific research, and infrastructure.

That’s just nuts!

Why the Fed hikes rates anyway

If crazy interest payments weren’t enough reason for the Fed to keep rates low, consider this.

“Interest rate increases that are faster than expected could push down stocks and commodities and trigger a domino effect,” warns financial security expert Pamela Yellen.

Another thing the Fed has to keep in mind is that a higher US interest rate hurts emerging markets (EMs).

EMs tend to rely heavily on foreign investment. When rates go up in the US, generally considered a safe haven, investors take their money and leave the generally riskier EMs.

Higher US interest rates cause another problem.

Many EMs, including Turkey and Argentina, have a lot of dollar-denominated debt. With interest going up and their currencies getting weaker against the dollar, these new conditions are making it harder for EMs to pay off their debts.

If EMs run into trouble, they could infect other parts of the globe and cause a problem for the world economy…

Why on earth is the Fed hiking rates then?

The official reason is that the Fed still sees strong growth in the US economy with the unemployment rate at its lowest in almost 50 years.

It’s raising rates rapidly in order to cool off an overheated economy and keep a lid on inflation. All of that may certainly play a role.

However…

“The real reason for Fed rate hikes is to prepare for a new recession,” writes Jim Rickards in his weekly briefing to Strategic Intelligence readers.

“Research shows that it takes about 4% in rate cuts to pull the US out of a recession. How do you cut 4% when rates are only 2.25% (the current level)?

“The answer is you can’t. If a recession started today and the Fed cut rates to zero, it wouldn’t be enough to stop the recession.”

The bull market in stocks has run over nine-and-a-half years. Bullish sentiment is fading. A recession could happen any day.

In the last crisis, central bankers acted as the superheroes who rescued the financial system from doom. But if they don’t get rates back up, their utility belts will be empty the next time they have to act.

Why does the Fed hike interest rates? It has no choice.

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