The market has priced in several rate cuts in 2024, but in reality the $1T+ federal deficit may force the Fed to increase interest rates. Here’s how:
1) This deficit mushroomed during COVID and exceeds $1T each year. In 2023, tax revenues were $4.8T and expenses $6.1T. Neither party is serious about addressing this.
2) The government has to borrow money to cover the deficit, which it does through selling Treasury bonds. A T-bond is a promise by the government to repay at a guaranteed interest rate, and the buyers are the government’s lenders. There are 2 lenders: the Fed and the public.
3) To buy T-bonds, the Fed prints money (Quantitative Easing). They don’t actually print cash, but digitally inject capital into the reserves of primary dealers (eg. JPMorgan, BofA, Citi).
4) The consequence of QE is that each dollar is worth less than before (because there are more of them). So monetary expansion/supply is inflationary.
5) To combat inflation, the Fed has decreased QE (= printing less money) and raised interest rates (to cool the economy).
6) When the government can’t depend on the Fed to lend it money because of the inflationary repercussions, then it has to rely on the public.
7) To compel the public to buy T-bonds (i.e. lend money), the Fed has to raise interest rates. The more the government needs to borrow, the higher interest rate they need to offer in order to attract enough lenders.
8) Over the past 2 years the rate hikes have helped both dampen the economy and attract more lenders. However, one day rising unemployment might prompt the government to seek lower rates to reinvigorate the economy again. Yet, lower rates would compromise the ability to attract lenders, challenging the government’s crucial borrowing needs. The Fed, facing a dilemma, would have to prioritize funding the deficit (higher rates) over stimulating the economy (lower rates), perpetuating a vicious cycle.
9) To make matters worse, the current higher interest rates also increase the government’s annual expenses. Interest payments have gone from $527B in 2020 to $875B in 2023. The US national debt recently surpassed $34T. The current rate on this debt is 3.11%, which equals ~$1T of annual interest payments, or 1/6 of the federal budget. The interest payments now approximate the current deficit (~$1.3T), so the US government is mainly borrowing to cover interest payments on old debt.
10) As the government’s annual interest payments rise, so does the deficit, and the need for even more debt. Jamie Dimon warned the US is driving towards a “cliff” a few days ago. It’s the same dynamic as someone who is paying down credit card debt with another credit card - it isn’t sustainable. In any case, don’t hold your breath for 0% interest rates again.
