The #1 Reason Why High Inflation Is the Nightmare Scenario

Why long-term debt matters more than short-term high prices

In case you haven’t noticed, Jerome Powell is doing his damndest impersonation of Paul Volcker, who famously killed inflation by burning down the economy in the late 70’s and early 80’s.

But there are a couple of key differences between now and then that show just how dangerous a path Powell and the Fed has set the US upon.

Historical Starting Points for FED Rate Increases

First, the effective Fed Funds Rate in 1977 was about 4.7%. Volcker’s rate increases jacked that up to about 17.6% in April 1980, and just over 19% in January 1981.

That’s about a 3x-4x increase in rates. Costly, but doable.

On the other hand, the effective Fed Funds Rate in January 2022 was 0.06%, with the current rate at 5.33%. That’s a 88x increase, which is wholly unsustainable. And my guess is that they’re not done yet.

Now, many people will say that you can’t compare the two because of the extreme and unprecedented low rate we had during COVID. There’s a little bit of truth to that, but my response is that we started with an extreme, which had extreme results (2.9% mortgages anyone?), so the current increases will also yield extreme results (worst housing market since 2009).

Debt-to-GDP Ratio

Second, the Debt-to-GDP ratio was about 33% in 1977 but has ballooned to 120% today. And this is the really big reason we’re going to have problems down the road.

The US has more debt than it ever has outside of war, and the market is finally clued in to this fact.

Everyone knows that higher Fed rates mean higher rates on the 10-year Treasury bill, which means higher interest rates on basically every debt instrument any standard American would have access to. This is expected and already cooked into the market.

A problem starts when investors start doubting the capabilities of the US to pay back that loan. Or at least the interest on that loan, which is the profit that investors care about. But we’re going to start having a problem with even paying that off very soon.

Relative to the size of the economy, interest costs in 2030 will reach 3.3 percent of gross domestic product (GDP), exceeding the previous post-World War II high of 3.2 percent of GDP, which was recorded in 1991.

Within 10 years, net interest costs will exceed federal spending on crucial programs like Medicaid and defense.

Spending for net interest will become the largest “program” in the federal budget within the next 30 years, outpacing spending on Medicare and Social Security.

That report was printed in February 2023. Costs will have only gotten higher since then.

Investors are none too happy about the state of affairs, and they are making it publicly known. Stanley Druckenmiller, the billionaire who formerly operated Duquesne Capital, has called Treasury Secretary Janet Yellen’s choice of bonds “political myopia”.

He claims that, at Yellen’s direction, the Treasury focused on issuing short-term bonds near 0.15% rather than long-term bonds that paid off 0.85%. While the lower price to the government looked good at the time, it looks downright horrific in the face of 5.0% bond rates.

In short, it was a short-sighted mistake not to issue 10 or 30 year bonds at less than 1% interest. I would tend to agree.

The Secret Impact of High Interest Rates

Interest payments are not the only problem facing the US budget due to high interest rates. The biggest issue that no one is talking about is Social Security and the impact on its budget.

Every year, Social Security recipients get a Cost of Living Allowance (COLA) that is based on the Q3 reading of inflation. The past two increases have been 5.9% in 2022 and a whopping 8.7% in 2023. 2024 will be a more manageable 3.2%.

But remember, Social Security is among the largest social programs in the country, and thousands of boomers are claiming Social Security every day. The impact will be exponential on the budget, giving debt service a ran for its money.

Already, the program will run out of money to fund full benefits in 2033, and I would be surprised if it even reaches 2030.

Peterson Foundation CEO Michael Peterson said ahead of the report’s release that “if lawmakers do nothing, in less than a decade more than 70 million beneficiaries would face an automatic 23% cut, reducing the average benefit by several thousand dollars per year. We simply can’t let that happen.”

But how are they going to stop it?

You can’t take on more debt, because our debt load is already too high.

You can’t cut benefits, or else you’ll have an entire generation of poor, old people who will either die or revolt.

It’s a problem that was entirely avoidable with small changes over the course of decades, but Congress just ignored it and went on spending like drunken sailors, but on the wrong things like trickle down economics.

The Takeaway

The government’s finances are going completely haywire. 20 years and trillions of dollars of war, disinvestment at home, and a widening wealth gap have made our country truly the poorest rich nation on earth.

No one is coming to save us because no one can, not even the government.