Why The Fed Cannot Afford To Keep Interest Rates High For Too Long

The Federal Reserve can only keep interest rates high for a short time. It must lower the cost of borrowing for the federal government, which keeps accumulating more elevated and higher debt.

The nation’s central bank’s interest rate policy is officially determined by a dual mandate, maintaining steady prices and maximum employment.

To achieve these goals, the Fed lowers interest rates when inflation is below its target of 2% and employment is below the maximum. Conversely, it raises interest rates when inflation rises above its mark and the labor market is too hot, as has been the case recently, with interest rates at a multi-year high.

Unofficially, the Fed has one more mandate: print money to buy Treasury bonds and keep borrowing rates low for the government. Economists call it “financial repression.”

If the federal government’s deficits keep growing, as has been the case in recent decades, high interest rates take a more significant chunk of GDP to serve it. Thus, the Fed has no choice but to keep interest rates low, even if that puts the nation’s central bank at risk of missing inflation targets.

“High-interest rates are a balancing act, Jeff Rose, CFP and founder of GoodFinancialCents.com, told the International Business Times. “They can temper inflation, currently at 3.67%, above the Fed’s 2% target. But, sustained high rates can suppress economic growth and increase unemployment, conflicting with the Fed’s goals of maximum employment and stable prices.”

Meanwhile, he sees high interest rates elevate the government’s borrowing costs, making debt service more expensive, particularly when running deficits. “There’s a perspective that by maintaining low rates, the Fed is practicing ‘financial repression,’ seemingly prioritizing government borrowing needs over its official mandates.”

Will Matheson, Co-Founder, and Managing Partner, provides further insight into the growing need for financial repression. “Many people point out that today’s rates are still comparatively low-interest rates,” he told IBT. “They were higher in the 80s, 90s, but the biggest difference between now and then is that even before the Great Recession, the debt to GDP ratio was only 55%.”

Matheson goes over some numbers to demonstrate the seriousness of the government financing problem. “If debt is 100% of GDP, paying 4.5% interest means 4.5% of all GDP is going towards debt service,” Matheson said.

“Unfortunately, our debt is now 120% of GDP, so 4.5% interest means that 5.4% of all GDP has to go towards debt service,” he added.

“The national debt is not immune from interest rate increases, and, in fact, since 2020, the money spent on interest payments has almost doubled,” added Richard Gardner, CEO of Modulus.

He is pointing to numbers from The Committee for a Responsible Federal Budget, which show that interest payments could double in less than a decade due to an increasing national debt and higher interest rates paid on Treasury notes.

“Our deficits aren’t going away anytime soon, so that number will only continue to grow,” added Matheson. “By 2053, debt is projected to hit 200% of GDP, meaning that 4.5% interest rates demand 9% of all GDP to go towards debt service.”

Meanwhile, Joe Camberato, the CEO of NationalBusinessCapital.com, is concerned about the financial repression stifling private sector growth – a bit of a catch-22. “While I’m all for the government’s efforts to rein in inflation and stabilize the economy by raising rates, we need to be careful not to overdo it, or we risk plunging into a deep recession,” he added.

He believes interest rates have to come down soon to help refinance the $1.5 trillion worth of commercial notes that are coming due. “The question is: how many of these notes or deals won’t be able to be refinanced due to the less-than-ideal debt ratios in this high-interest-rate environment?” he added.

Robert Goldberg, clinical associate professor of finance and economics at Adelphi University in New York, sees the Fed will have a tough time justifying a return to a low-rate environment, “meaning that tough fiscal choices are going to need to be made.”