Will Higher Interest Rates Solve Inflation or Break the Economy?
At the June FOMC (Federal Open Market Committee) meeting, the Federal Reserve raised interest rates by 0.75% or 75 basis points. The expectation has been that another 0.75% will happen at the July 26-27 meeting.
The inflation data just came out at 9.1%, and wage growth isn't anywhere near inflation. Fed Governor Christopher Waller said he expects a 75-basis point but is open to a more significant move depending on the data. Many Wall Street traders are now betting that the Federal Reserve will raise interest rates by one full percent due to Waller's comment.
The Fed primarily raises interest rates to slow down customer demand. In theory, fewer buyers will be in the market if money becomes more expensive for debt-based purchases like cars and houses. To attract the buyers back into the market, sellers will lower prices. On paper and in a perfect world, it works every time. However, no one lives on paper or in a perfect world.
Many factors dating back decades are responsible for causing inflation. Will rising interest rates solve the supply chain issues and bring peace to Europe? Probably not. Will rising interest rates stop bad politics or provoke politicians to stop over-promising and under-delivering in the most expensive way possible? Probably not. Will rising interest rates hurt more everyday people than fat cats sitting in ivory towers? Probably.
The most predictable outcome of rising interest rates is what happens every time. The Fed will overdo their response and break something else in the economy. When the Fed “solved” inflation in the 1980s with 20% interest rates, it led to two years of high unemployment.
Unemployment is not the most immediate danger. A significant difference between 2022 and 1980 is the amount of government debt. The four most oversized government budget items in order are Medicare/Medicaid, Social Security, Defense/War, and interest on the debt. High inflation and higher interest rates immediately put affordable healthcare and social security in harm's way. High unemployment comes later. If the Fed breaks the economy now, it would most likely be a snowball of worst possible outcomes for the unprepared.
In 1980, the U.S. debt was unthinkable at the time, at $900 billion, and annual government spending was $560 billion. Adjusted for inflation, $560 billion in 1980 would equate to $2.01 trillion in 2022 dollars.
Today, the debt is a dizzying $30.5 trillion, and annual spending is more than $6 trillion, three times the size of 1980. Unfunded liabilities total more than $91 Trillion. All $91 Trillion will have to be debt at the interest rate until it eventually becomes taxes. If the U.S. government taxed every individual and business at 100% for the next five years, this would not pay the debt. Can you imagine if you had credit card debt totaling more than the next five years of your income? Sadly, this is the situation the government freely admits. Who knows the actual numbers? Politicians seem to have a magic accounting pencil that manipulates numbers. (You know the pencil. It’s like a magic eight ball that answers questions but is terrible at math. “Magic pencil, energy is up 40%, groceries are up 12.2%, and housing is up around 17%. Magic pencil, what is the current inflation?” “Inflation is 9.1%”)
Since higher interest rates make debt-based purchases more expensive, what does it cost to operate the U.S. government going forward? The higher the interest rate, the faster the U.S. runs out of money and outside funding sources. Suppose history accurately predicts behavior when government debt becomes unsustainable and debt is no longer an option. In that case, history says desperation and massive printing are coming. Printing will happen quickly until the currency collapses, like in Zimbabwe, Weimar Germany, Argentina, Hungary, Peru, Angola, Belarus, and so many more.
With so many crises happening simultaneously, it is anyone’s guess what breaks first and what life may look like on the other side.
The fact that there are unknowns is why people diversify their portfolios. The big idea of diversification is mitigating risk by having as many points of failure as possible. Some say, "don't have all your eggs in one basket." If all your eggs are in one basket and there is an accident, then you don't have any eggs left. It would be best if you had multiple baskets to keep your eggs. When you have multiple baskets of eggs in different places, there is a better chance you will still have eggs when disaster strikes. It looks like interest rates are about to break some eggs. Are you prepared?
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