Inflation, Deficits and Coping With Compounding Debt
At the IMF Annual Research Conference on Nov. 9, Federal Reserve chair Jerome Powell stated: “The Federal Open Market Committee is committed to achieving a stance of monetary policy that is sufficiently restrictive to bring inflation down to 2% over time; we are not confident that we have achieved such a stance.”
According to my translation of Fed-speak, that means inflation is not under control. Hence, one of two situations is foreseeable: either there would need to be a much higher interest rate to bring down inflation (which may crash the economy), or we must tolerate higher inflation for longer.
Given that a) there is the need or temptation to inflate away the debt and b) the Fed, in my opinion, has a bias against triggering a recession, especially in a pre-election period, the higher inflation rate scenario is likelier to prevail.
The S&P immediately fell 220 points after Powell’s statement. Let’s examine»a little more closely some of the mechanisms at play here.
Deficits out of Control
As a percentage of GDP, the U.S. deficit was 6.3% for the year ended Sep. 30, an increase from 5.4% in FY 2022, and is expected to remain at a remarkably high 7-8% over the coming years. The United States does not have a monopoly on this phenomenon. Italy had a deficit of nearly 8%, Hungary is at more than 6%.
Fed Must Float More Treasuries
Deficits need to be financed. Central banks can print money (which is inflationary beyond a certain point) or sell Treasuries. With the Fed trying to bring down very high inflation rates, it has chosen to sell Treasury bonds to finance recent deficits rather than print money and has sold huge quantities over the past months.
As with most markets, the price of Treasuries (in other words, interest rates) is governed by supply and demand. On the Nov. 9 Treasury sale, the Fed tried to sell USD 24 billion worth of bonds and failed due to low demand. This triggered a remarkable spike in interest rates.
The U.S. Treasury has colossal financing requirements, having financed USD 1.5 trillion in the last four months, and is estimated to require a further USD 1.5 tln in the coming six months. This surge in financing requirements comes when the primary treasury holders (China, Japan, Russia) have switched from net buyers to net sellers.
When the supply of bonds dramatically exceeds demand, there may be a loss in market confidence, causing the central bank to lose control over interest rates. Moody’s has just downgraded its outlook on U.S. Treasuries from “stable” to “neutral,” which it justified by the rising interest rates and lack of adequate policy measures to contain deficits.
Nominal Debt Increasing
To put the above numbers into perspective, in September 2023, total U.S. federal debt recently passed the USD 33 tln mark. The national debt has grown by approximately 10% in less than a year.
Note the steepening curve on the graph. This approximates a typical curve showing a compounding effect. This curve will likely continue to steepen unless policy measures are taken to control deficits.
The same is true with the curve for interest costs: according to the U.S. Congressional Budget Office, net interest payments on the federal debt were USD 475 bln in 2022 and are projected to rise to USD 640 bln in 2023. This trend is likely to accelerate further due to a combination of increasing debt levels and refinancing existing low-interest debt in the portfolio, as it becomes due, with more expensive debt.
This may result either in a debt spiral and/or the squeezing out of other spending. The latter is already happening throughout the developing world. According to the IMF, at least 100 countries must reduce spending on health, education and social protection to meet debt payments.
When low-income countries go into debt distress, this may result in “protracted recessions, high inflation and fewer resources going to essential sectors like health, education and social safety nets, with a disproportionate impact on the poor,” according to the World Bank.
Should debt continue to grow exponentially (in other words, along its current path), such effects could also affect the United States and other developed countries. It is important to highlight the compounding effect of debt growth curves and the corresponding cost of debt service. The human mind is somehow programmed to think in linear terms; we are often surprised by the cumulative effects of compound curves and how difficult they are to reverse.
If confidence is lost and interest rates rise, the compounding effect can suddenly and unexpectedly accelerate even further. As Albert Einstein once said: “The most powerful force in the universe is compound interest.”
Les Nemethy is CEO of Euro-Phoenix Financial Advisers Ltd. (www.europhoenix.com), a Central European corporate finance firm. He is a former World Banker, author of Business Exit Planning (www.businessexitplanningbook.com), and a previous president of the American Chamber of Commerce in Hungary.
This article was first published in the Budapest Business Journal print issue of November 17, 2023.
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