One might ask, Why is it a problem that the Fed keeps interest rates low to devalue our debt interest payments?â Having a simple understanding of economics assists you in answering this question.
To simplify things, imagine three dominoes. The first domino we will call The Fedâ, the second domino we will call Inflationâ and the third domino will be named Interest Ratesâ.
These dominoes are lined up one after the other, with the Fedâ as the first domino and “interest rates” as the last. As with regular dominoes, when you knock over the first, a force is exerted on the second, causing it to fall and exert a force on the third. This is the order of operations by which the Fed controls interest, and thereby controls our debt payments.
The Fed’s main policy tool is called open market operations. This is the buying and selling of debt, in the form of US government securities such as Treasury bills, notes, bonds and TIPS. When the Fed, through open market operations buys bonds, the Fed receives the bond and debt-holders (such as the US public and foreign nations) receive cash for their bonds. Therefore, when the Fed buys bonds, it injects liquidity into the economy by increasing the amount of dollars available to the public. The reverse is true of the Fed selling bonds; in this instance the Fed gets cash and US corporations, citizens and foreign counties get US government debt.
Over the past ten years on net, with the exception of the last three years (which we’ll get to), the Fed has been keeping liquidity in the economy to a minimum by selling US government securities. This regulation of cash in the economy has created a situation where inflation cannot rise rapidly. This is a simple example of supply and demand, whereby the fewer dollars that are in the â˜system’ creates a situation of scarcity causing each dollar to be more valuable. Conversely, if there are more dollars in the economy, price levels tend to rise because each dollar is worth less and there are more nominal dollars.
The definition of inflation is â˜a general rise in the level of prices, causing purchasing power per dollar to decline’. Because dollars have been predominantly scarce (comparatively), price levels did not have the opportunity to rise and inflation was kept to a nominal 1-3%.
Interest rates, our third domino, are usually based on inflation. Why do I say â˜usually’? Well, as inflation rises, even marginally, it only makes sense that interest rates would have to rise higher to provide a positive return on investments for those lending money. Over the past ten years, our real interest rates have been a negative percentage (or zero) because inflation, as low as it has been, has actually outpaced lending rates. This has allowed the US government to pay off its debt in â˜cheapened’ dollars, as inflation has slowly eroded away the value of the dollars that we are paying back, while the interest rate has been stuck below the value of inflation.
All fine and dandy right? We are paying back our debt in cheaper dollarsâ¦sounds great! ⦠Wrong! In the background, while the Fed and government are utilizing monetary and fiscal policy in attempting to save themselves from going broke with interest payments they cannot afford, our debt continues to increase beyond what we are paying back.
The real amount that we owe is ever climbing, and the moral hazard presented by allowing interest payments to be negative means the government will continue to borrow and ride the Fed’s good gracesâ until we have spent ourselves into oblivion. Eventually, the real interest rate will have to be constantly zero so the government doesn’t become insolvent, leading to would-be creditors not wanting to lend money and receive negative return on investment, leading to zero economic growth, leading to layoffs, depression, government dissolution, etceteraâ¦but we’ll save that for the Futureâ article. Aren’t you excited to learn about your future?
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