In what was likely one of the most significant economic moves of the decade, 2022 saw a series of adjustments to the Federal interest rate. Through repeated adjustments at the end of each quarter, the Board of Governors of the Federal Reserve System brought the interest rate paid on reserve balances up by 3.9%.
This decision was ostensibly part of a larger package of measures meant to curb inflation, which had surged to 9.1% earlier this year. And yet, according to economist Brian Riedl, the decision to raise interest rates could bring much more economic woes than the inflation it is meant to cure.
Rising Inflation vs. Rising Interest Rates
Although inflation is closely linked to the Federal interest rate, they are not the same, and their impact on the economy is also different.
“Inflation” refers to the progressive loss of purchasing power of a specific currency. Its main symptom is the inflation of prices across the board, which make the same amount of money worth progressively less. Often, inflation is simply a side effect of a booming economy: more jobs and higher wages increase the available cash in everyone’s pocket. Demand rises, offer stays the same, and prices go up. When out of control, inflation can severely impact the standard of living of middle and working-class families.
Interest rates often rise as a result of inflation. If a currency loses value, creditors need to compensate by increasing their revenue. And yet, the effects of high-interest rates can be much more harmful to the Federal Government. Inflation automatically increases government revenues, and as a result, spending formulas often fall into place automatically. Likewise, inflation passes – while interest rates tend to stay higher even long after the economic cycle has moved on.
What Could Happen due to Higher Interest Rates?
Without proper precautions, high-interest rates have three distinct yet powerful effects on government budgets.
1. Spiral debt payments out of control
Higher interest rates will also increase the amount of money the Government needs to pay back to its bondholders on a quarterly or yearly basis. Fulfilling these payments is essential for keeping the country’s credit rating.
Often, to increase revenue enough to meet these payments, governments are forced to boost the economy for the short term, even artificially. This can increase inflation, which may drive interest rates even higher.
2. Increase budget deficits
According to the Congressional Budget Office, the Federal Government expects an accumulated deficit of $100 trillion over the next 30 years. Higher debt installments can drive this even further: for every percentage point added to the federal interest rate, the Government will spend an extra $2.6 trillion over the next ten years. With this, the Government may struggle to meet its routine obligations and programs – not to mention any large-scale investment or infrastructure projects.
3. The collapse of Social Security and Medicare
The extra expenses from the interest rates will combine with another looming economic crisis: the impending retirement of the Baby Boomer generation. Over the next decade, the Government will need to settle a massive bill to one of its largest demographics, mainly in the form of healthcare and pensions.
Will it be able to meet both obligations?
Are We At Risk of Further Rate Hikes?
The rate hikes announced throughout 2022 have already raised concerns among many political analysts. According to Riedl, the current situation is manageable as long as we see no further increases in the short or mid-term.
Yet, this is unlikely. A quick look at our debt-to-GDP ratio and the trends experienced by other developed nations announce further costs and uncertainty for all.
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