Who really benefits from inflation?

Does the Federal Reserve deserve credit for slaying the inflation dragon? Or is it more likely that any headway we’ve seen lately is a function of healing supply chains? The answer to that question appears to be a solid “maybe.”

When the Fed raises rates, it’s supposed to reduce demand by draining liquidity from the system in the form of higher interest payments. But what if the rapidity of the rate rise, coupled with the previous interest rate environment, results in locking up supply and reducing transactions?

For this thesis to make any sense, we need to consider a couple of factors. First, let’s look at the extraordinary duration roll that occurred since 2019. An easy way to understand this is to look at an average homeowner with a mortgage. Let’s assume that in 2019, you had a three-year adjustable-rate mortgage with a 2.50% interest rate. After the extraordinary Fed actions of 2020, a 30-year fixed rate had the same interest rate as a shorter-term adjustable rate. This created an incentive to “roll” your mortgage into the 30-year and effectively insulate yourself from any rise in rates.

These extraordinarily low rates also encouraged those without a mortgage to borrow at the new rate. Here are some statistics to underscore the massive effect this had. In 2019, 1% of U.S. mortgage holders had an interest rate under 3%. That number has currently ballooned to 19%. In 2019, 37% of U.S. mortgage holders had a rate under 4%. That number is now almost 60%. Of course, this phenomenon exists not just in mortgages but for most borrowers, including businesses big and small.

Pumping $1 trillion into the economy every year isn’t disinflationary. At all.

The point here is that far more borrowers took advantage of historically low yields across the curve before the hiking cycle got under way, and they are now largely insulated from the effects of higher rates.

The rapidity of the Fed’s hiking cycle created a broad death grip on any loan that was issued between 2017 and 2022. During this period, 10-year Treasury yields averaged a historically low 1.96%. The massive mistake that the Fed made in dragging its feet on increasing interest rates amounts to a game of debt musical chairs, wherein the timing of your transaction largely dictated your success.

Well, your cost of capital, anyway. The quickly soaring rate picture was “tick tock, the game is locked, and nobody else can play” for anyone who wished to buy a home or start a business after the interest rate rocket ship blasted off in March 2022.

Now for the other side of the equation. In 2020, the U.S. Treasury paid around $500 billion a year in interest payments. Now, due to soaring rates and increased borrowing “need,” that number is closer to $1 trillion. Not that you need me to do the math, but that’s $500 billion more and $1 trillion total pumped into the economy every year. That isn’t disinflationary. At all.

For additional context, the Treasury’s average interest on its outstanding debt was 2.4%. That number has now increased to around 3%, despite current rates being much higher.

Tell ’em the good part, Mortimer!

The average time to maturity on our massive $34 trillion national debt is around six years, with 22% ($7.5 trillion) maturing in the next year.

So, just for fun, let’s do a quick thumbnail on how interest payments will explode in the next several years. If next year’s maturities are rolled into current rates — let’s say 5% — that would raise the Treasury’s average interest rate to 3.4% and would raise the net amount the Treasury injects into the global economy to $1.156 trillion per year.

Of course, this example is wildly unscientific and laughably assumes zero new debt. If half the current debt were rolled in the next four years, the rate the Treasury would pay out would increase to an average of 4%, and interest payments would jump 20% to $1.2 trillion.

But wait! There’s more!

Reality is much worse than the above model implies.

Independent of increasing debt service, the federal government has been exploding the national debt. Total public debt since June rose from $31.5 trillion to the current level of $34 trillion. That’s in five months. The whole thing is crazy.

At a time when the federal government was supposed to be imposing some austerity to cut spending, it did the exact opposite. Congress approved massive spending packages like the Inflation Reduction Act while the Biden administration rolled out its multibillion-dollar loan payment forgiveness and forbearance policy.

And let’s not forget the wars. Treasury Secretary Janet Yellen told Sky News in October, “America can certainly afford to stand with Israel and to support Israel's military needs and we also can and must support Ukraine in its struggle against Russia.” With all due respect, America can’t even afford peace!

The only reasonable conclusion is that the government wanted the inflation. The powers that be wanted it to bail out excessive borrowers like themselves and states such as California, Illinois, and New Jersey that remain buried in pension debt with no reasonable plan to pay their bills. That scheme would work if those being bailed out embraced real spending restraints. They won't.