Rain on the Parade.

What is “normal”?[1]  For decades before 2020, “normal” was a slow-growth economy; an aging population moving out of the labor force to begin drawing on retirement savings; a world awash in such savings; and an international demand for dollars as a safe-haven. 

The financial manifestations of this “normal” were “negative” real interest rates (i.e. below the low rate of inflation); real bond yields below 1 percent; rising prices for stocks and housing;[2] the cost of borrowing for businesses were low and corporate debt expanded relative to Gross Domestic Product (GDP); and nobody worried much about expanding government deficits and debt because the cost of servicing that debt did not grow.  So it would continue: The Biden administration’s early budget projections foresaw a decade of near-zero real short-term interest rates and a real bond yield of 1 percent. 

Then inflation surged to unexpected heights.  The Federal Reserve Bank raised interest rates sharply and says that it will go on raising them; and a “soft landing” may be impossible.  Nothing daunted, people now say that temporary rate hikes and a recession are the price you have to pay.  By 2024, we ought to be back to “normal.”  Financial markets seem to anticipate that the Fed will raise interest rates another 2 percent by Spring 2023.  After that it will begin working them down. 

But what if this isn’t what happens?  What if inflation remains stubbornly high?  What if the Fed has to push nominal interest rates (interest rates without inflation rate subtracted) as high as 7 percent and perhaps hold them there for longer than people currently expect? 

According to one projection, the ordinary person could get caught in a vise with the prices of houses and stocks and bonds down by as much as 5 percent, while private-sector debt service ate up another 3 percent of income. 

But wait!  There’s more!  Specifically, the federal government[3] borrowed a lot of money when the costs were low.  Back in the day, publicly-held debt amounted to 35 percent of GDP; now it is up to 98 percent of GDP.  Falling bond-yields off-set the rise in debt, so no one has felt the pinch yet.  Short-term debt has to be constantly renewed, so rising interest rates will push up the interest cost pretty quickly.  A Congressional Budget Office estimate projects that a 1 percentage point increase in real interest rates will increase the deficit by $250 billion.  Sooner or later, this would force our polarized (almost paralyzed) political system to find a solution involving spending cuts and tax increases.   

Recently, a friend related to me his sad tale of woe.  He had had borrowed $150,000 when interest rates were low.  He was paying 3.5 percent to the bank, with a monthly interest component $416.26.  Then the interest rate went to 3.75 percent and he paid $438.59 in interest.  Then it went to 4.25 percent and he paid $512.94.  Then it went to 5 percent and he owed $541.11.  So, he’s out an extra $125 a month.  He finds this “concerning.”  

Still, why would inflation remain stubbornly high?  Perhaps it will not. 


[1] Greg Ip, “Interest-Rate Pain Has Barely Begun,” WSJ, 21 July 2022. 

[2] Great if you already owned a bunch of stocks and bonds in your retirement account and a paid-off house.  Which I did. 

[3] That is, the American public borrowed the money, mostly to finance wars, and tax cuts I think.  There’s probably a squalid argument to be had over the stupidly-phrased “Makers versus Takers” theme launched by Mitt Romney.