Peter Morici: Higher interest rates are fueling inflation and taxing America’s innovation and growth

U.S. interest rates have surged in the past few months. If this persists, it has serious consequences for the sustainability of federal deficits and U.S. economic growth.

The Federal Reserve increased the federal funds rate 25 basis points on July 27. Subsequently and until the Hamas attack on Israel on Oct. 7, the yield on 10-year U.S. Treasurys
which provide a benchmark for long rates such as for mortgages and corporate bonds, jumped nearly a full percentage point to 4.8%.  This likely caught Federal Reserve policymakers and most economists by surprise.

For bond investors, when interest rates rise on newly issued debt, the market value of prior-dated securities falls. The late July through early October bond rout may have been the worst in 150 years. Bondholders’ losses rivaled those that stock investors took in the 2008 global financial crisis.

For too long, bond investors and policymakers have ignored the warning signs. In 2011, U.S. debt was downgraded, but that was easy to blow off. Then as now, the U.S. dollar

is the vehicle currency for the vast majority of foreign exchange transactions. Foreign central banks hold much more in interest-bearing U.S. Treasury securities as reserves than assets in other currencies, and historically that boosts demand for U.S. debt.

Meanwhile, federal deficits have continued to grow, and the way Washington spends is neither efficient nor adds enough to economic growth. For example, the U.S. far outspends Russia and China combined on defense, but China has a larger navy. America’s armed forces would be challenged to defend Taiwan or critical lanes of commerce in the South China Sea.

Generally, Republicans have been inclined to lowered taxes, Democrats to increase entitlements, and neither political party is much interested in raising taxes on working and middle-class Americans.

It’s hard to argue that the Biden administration is spending on infrastructure and industrial policy as effectively as it could. For starters, money lent and loans forgiven to college students adds to the federal deficit and is not producing the skilled labor force the economy requires.

U.S. foreign policy reliance on sanctions — in particular, access to the dollar payment system — has soured larger non-Western governments on the dollar.

Nonetheless, it would be tough to replace the dollar as the vehicle currency. The network effect makes it more convenient to have one currency for most international transactions, and the dollar has an entrenched settlement infrastructure.

However, central banks in Brazil, China, Japan, Saudi Arabia and elsewhere are selling or reducing dollar purchases. That curbs the overall demand for U.S. Treasurys.

In their place, hedge funds, mutual funds, insurers and pension funds will play a greater role in financing U.S. debt, and this will add to the volatility of Treasury security prices and increase rates.

European nations are caught in budget difficulties too. They must spend more on defense with Russia, Iran and China behaving so aggressively, or face a grim future for democracy and a less secure world for their businesses and citizens.

With aging populations, the costs of replacing Russian natural gas and decarbonization, their governments are running larger post-COVID deficits than before the pandemic. That additional debt reduces the demand for dollar-denominated securities.

The United States will not default on its debt. But with the federal deficit at $1.7 trillion in fiscal 2023 and likely to grow without major cuts in entitlement and defense spending or life-style reducing tax increases, the U.S. Treasury is pushing more debt on global markets than buyers are willing to finance for less than 5% on the 10-year Treasury.

Interest rates have pulled back — the 10-year Treasury rate currently is 4.6% — but the cumulative effects of large deficits are becoming burdensome. The Fed now is selling off the Treasury securities it acquired during the pandemic, but it could start buying bonds again. That would create a larger money supply and inflation, and investors would demand even higher interest rates.

Read: Giant bond investor says buy bonds now and you’ll ‘be rewarded’

Near term, many banks face default and corporate bankruptcies. Shaky small businesses and landlords with commercial office buildings made less valuable by work-from-home can no longer borrow cheaply. Meanwhile, homeowners locked into cheaper mortgages are reluctant to sell until their circumstances change and they must move.

A lot of innovation in America has been driven by cheap capital. Consider all the startups financed by angel investors that until now did not have a good place to park their money. With higher rates, funding for projects to create new apps or build out artificial intelligence — or to finance windmills and solar farms — will become scarcer.

In the end, a government that borrows a lot and spends money poorly taxes its citizens through inflation and slower growth.

Peter Morici is an economist and emeritus business professor at the University of Maryland, and a national columnist.

More: Turns out that inflation really was transitory, no thanks to the Fed

Also read: It’s hard to believe, but emerging markets are handling debt better than the U.S.

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