Is the US at risk of falling into a debt trap?

The Federal Reserve started to increase interest rates in the United States in March of 2022 and has quickly raised the borrowing rate at commercial banks to more than 5.25% over the last couple of years. The Fed started to increase the short-term borrowing rate to tame inflation. While the goal of the Fed is to reduce borrowing, which can reduce growth and price increases, it also makes borrowing by the U.S. Treasury more expensive, which could put the United States into a debt trap. 

What is a Debt Trap

A debt trap refers to a situation where a person or an entity becomes trapped in a cycle of debt with little or no ability to escape. It usually occurs when someone borrows money to meet their immediate needs but finds it challenging to repay the debt due to high-interest rates, penalties, or a lack of resources. As the debt accumulates, it becomes increasingly difficult for the individual or entity to break free from the cycle, often leading to financial instability and further borrowing. Debt traps can have severe consequences, making it essential to manage finances.

What Caused the Fed to Raise Rates

Several factors may cause the Federal Reserve (Fed) to raise interest rates. The primary goal of the Fed is to maintain price stability and promote sustainable economic growth. When the economy is overheating or inflationary pressures are building up, the Fed may increase interest rates to cool down the economy and prevent excessive inflation. This situation helps to balance economic growth while ensuring that inflation remains within a target range. Other factors, such as solid employment data or concerns about asset bubbles, can also influence the Fed's rate decisions. 

The Backdrop to the Fed Raising Rates

The stimulative policy was needed during the COVID-19 pandemic. Losing jobs and low growth led to accommodative monetary and fiscal policy. Accommodative monetary policy is a strategy central banks adopt to stimulate economic growth by keeping interest rates low and increasing the money supply. The aim is to encourage borrowing and investment, which can lead to increased consumer spending, business expansion, and job creation. This policy is usually implemented during times of economic weakness or recession to provide a boost to the economy. Central banks hope to promote economic recovery and maintain price stability by making credit more affordable and abundant. 

Simulative fiscal policy uses government spending and taxation measures to stimulate or boost economic activity during periods of low growth or recession. It involves increasing government spending or reducing taxes to increase aggregate demand in an economy. By injecting more money into the economy, simulative fiscal policy encourages consumer spending, business investment, and overall economic growth. Governments often use this approach as a countercyclical measure to mitigate the adverse effects of an economic downturn.

In addition, the pandemic created issues with the movement of goods. A supply chain disruption is an interruption or disturbance in the flow of goods, services, or information within a supply chain network. It occurs when some challenges or issues prevent the smooth and timely movement of products or materials along the supply chain. Supply chain disruptions can happen for various reasons, including natural disasters (like earthquakes, hurricanes, or floods), labor strikes, transportation disruptions, supplier bankruptcies, trade disputes, or unexpected events such as the COVID-19 pandemic. 

These disruptions can significantly impact businesses, leading to delays in production, inventory shortages, increased costs, and ultimately affecting the availability of products or services for consumers. Supply chain management aims to minimize disruptions and build resilience to ensure the efficient and reliable functioning of the supply chain.

The combination of higher liquidity due to accommodative monetary and fiscal policy, supply chain disruptions, and the lack of labor quickly pushed prices higher. To reverse the surge in inflation, the Fed sought to reduce borrowing by raising rates. Now that the Fed is near the end of its tithing cycle, they are keen to let the marketplace know that they will likely keep interest rates higher for longer. 

When the Federal Reserve uses the phrase "higher for longer," it typically refers to the central bank's intention to maintain high interest rates for an extended period. This strategy is implemented to restrict economic growth and discourage borrowing and investment. By keeping interest rates high for a longer duration, the Fed aims to limit borrowing and spending, which can help slow the economy and inflation.

How do Higher Interest Rates impact Rolling Debt?

When interest rates increase, rolling debt can be impacted in several ways. First, let's define rolling debt. Rolling debt refers to debt that is constantly refinanced or renewed, typically through short-term loans or credit facilities. This scenario allows borrowers to borrow money as needed continually. An example would be the United States of America. The country constantly needs funds, and the Treasury is responsible for issuing debt and borrowing money on a rolling basis.

When interest rates rise, it generally becomes more expensive to borrow money. As a result, borrowers may face higher interest expenses when refinancing or renewing their debt. This issue can increase the overall cost of servicing the debt.

Higher interest rates can also lead to decreased borrowing capacity. Lenders might be more cautious about extending credit or require higher interest rates to compensate for the increased risk. In the case of the United States, lenders are bondholders. This scenario can limit the amount of money borrowers can access and potentially impact their ability to meet their financing needs.

If rolling debt includes variable-rate loans, higher interest rates can increase interest payments on existing debt. This, in turn, may put pressure on borrowers to manage their cash flow effectively and meet their repayment obligations. The rolling debt generally means that you are not borrowing all you need to borrow at one time. 

Fixed debt typically refers to loans or financial obligations with a predetermined interest rate that remains constant throughout the loan term. If you have a fixed-rate loan, your interest rate stays unchanged even if the market interest rates increase. In this case, your loan payments will remain unchanged.

Can Declining Interest Rates Relieve a Debt Trap?

Depending on the circumstances, declining interest rates can relieve individuals trapped in a debt cycle. When interest rates decrease, it often means that borrowing becomes cheaper. This can lower the cost of servicing existing debt, making it more manageable for individuals struggling with repayments.

If someone is trapped in a debt cycle with high-interest loans, declining interest rates might allow them to refinance their debt at lower rates, reducing their overall debt burden. With lower interest rates, a more significant portion of their payments can go towards paying off the principal rather than interest.

When Does the Fed Cut Interest Rates

The Federal Reserve is based on inflation, economic growth, employment rates, and other economic indicators. They have two mandates, which are price stability and maximum employment. Price stability refers to inflation.

According to the Federal Reserve, price stability is a low and stable inflation rate over time. It means that the overall level of prices in an economy remains relatively consistent without experiencing significant or rapid increases (inflation) or decreases (deflation). The Federal Reserve strives to maintain price stability as one of its mandates to promote a healthy and sustainable economy. By keeping inflation in check, the Fed aims to preserve the purchasing power of money and support long-term economic growth. The target inflation rate may vary, but the general goal is to achieve a moderate and predictable level of price increases.

According to the Federal Reserve, maximum employment refers to the level of employment where all individuals willing and able to work can find jobs. It is an essential goal for the Federal Reserve as it seeks to promote a strong and stable economy. While the concept of maximum employment is not precisely defined, the Federal Reserve aims to maximize employment by promoting conditions that can support sustainable economic growth and low unemployment rates.

According to the CME Fed Watch Tool, the Federal Reserve is not expected to begin lowering interest rates until the middle of 2024. The tool shows when market participants speculate that the Federal Reserve (Fed) will lower interest rates. The Fed's decisions regarding interest rates significantly impact the overall economy. Hence, traders, investors, and analysts closely monitor the statements and actions of the Federal Reserve officials to predict potential rate changes. Economic indicators, inflation expectations, and monetary policy outlook often contribute to these speculations. 

The Bottom Line

The upshot is that the Fed has decided to stay higher for longer, which could create a debt problem. A debt cycle occurs when rolling debt and interest rates rise quickly, pushing the borrowing rate for renewable loans. The U.S. Treasury is now forced into borrowing by issuing bonds and notes at higher levels than just a few years ago. If the Fed decides to lower interest rates, this move could help the Treasury by reducing the cost of borrowing. Still, if the Fed waits too long, it could put the United States into a recession and require additional borrowing to stimulate the economy, further creating a debt trap.