Everybody knows that federal debt has exploded. We are now at $18 trillion! Everybody bemoans the fact that it will be difficult to payback and that our kids have a massive burden.
I want to highlight a concern that is never mentioned.
For years, I pooh-poohed the debt gloom and doomers because the amount of debt was small compared to the size of the economy.
Like a family, you can have a small amount of debt to help you buy a house or car if the amount of debt is small compared to your income or your assets. That was the situation with the US for decades.
But I fear that we have passed that point now.
Take a look at the second chart. This shows the interest payments that the Federal government pays. You can see that the Federal government is currently paying about $450 billion per year in interest payments. And this is with interest rates at their lowest level in history!
What happens if interest rates go back to normal levels? The average of short term interest rates over the last 20 years is about 5% and it is effectively zero right now. Long term interest rates are below 3% when the long term average is closer to 6%. So let’s assume that a return to normal would boost interest payments to $1 trillion per year!
That means that a full one quarter of all Federal government expenditures will be interest payments! That is money that could go to more productive uses!
But here is the real problem. We are now entering the stage where the interest payments are compounding. In other words, we are paying interest on the interest!
This means that interest payments will become a larger and larger portion of the federal budget. It has reached a point that is truly disastrous. The compounding of interest will keep growing. It will start to grow at an exponential rate, with a sharp acceleration when interest rates start to rise.
The Fed has been buying all the debt of the US Treasury since the last recession thus enabling the massive increase in debt. The Fed has kept interest rates near zero, thus enabling the massive increase in debt.
One good thing is that the budget deficit is decreasing though still massive.
But here is what is going to happen.
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The debt will continue to grow by about a half trillion dollars a year. This means that interest payments will continue to rise with an accelerating pace. At the same time, interest rates will rise very slowly but every increase will increase the rate of increase of federal interest payments.
Soon, interest payments will be $1 trillion per year then $2 trillion and so on.
It won’t be many years before interest payment will be 1/4, 1/2, and eventually all the federal budget. Of course, it can’t be the whole budget but it will be squeezing all other expenditures.
Clearly this is not sustainable.
So how will this all end?
I look for the Fed to keep interest rates lower longer than anyone else. They know what I’m talking about here and will not want to increase the interest burden on the federal government.
In addition, I look for the Fed to double down on an effort to boost inflation. The only way to really decrease the interest burden is to make sure that inflation is higher that interest rates. That is called negative interest rates and negative interest rates are great for borrowers because the value of the debt goes down.
So look for much higher inflation down the road.
Eventually, we will see lower bond prices and will actually see one of the greatest bear markets in history.
At first, this will boost the stock market but eventually cut the legs out from under it.