I\u2019m about to tell you everything the Fed doesn\u2019t want to say to you.\u00a0<\/span><\/p>\n Let\u2019s start with the obvious: Most of us don\u2019t like to see\u00a0<\/span>interest rates rise<\/span><\/a>. Sure, it\u2019s nice to make a little bit of extra money off our savings accounts, but the higher cost of mortgages, consumer loans, and all other forms of credit isn\u2019t worth a few extra dollars of interest in our bank accounts.<\/span>\u00a0<\/span><\/p>\n But here\u2019s the thing.<\/span><\/p>\n The best way to quell inflation is to raise interest rates. This does two things:<\/span><\/p>\n When people are spending less and saving more, demand decreases. When demand decreases, prices go down.<\/span><\/p>\n But how high do interest rates need to go to calm inflation?<\/span><\/p>\n The conventional wisdom is that nominal interest rates<\/a> (the actual interest rate number) must be higher than the inflation rate to reduce inflation. This is because people need to understand that they are not losing value by holding cash. Rates higher than inflation will allow us to not lose money by saving.<\/span><\/p>\n With inflation at around 8%, you may be thinking that it means we need to raise rates from the current 1% mark to over 8%. But luckily, that\u2019s not the case. As rates start to rise, inflation starts to subside, and there will be some point of equalization somewhere between the current 1% interest rate and the 8% inflation rate.<\/span>\u00a0<\/span><\/p>\n Where is equilibrium? Nobody knows.\u00a0<\/span><\/p>\n It may be that raising rates to 2% is enough to drop inflation back to 2%, a number we should all be pretty comfortable with. But it\u2019s also possible that we may need to raise rates to 4%, 5%, or more to achieve the desired goal.\u00a0<\/span><\/p>\n In theory, the right move would be to continue to raise rates a little at a time until we hit that equilibrium. And then perhaps a little bit more to push inflation down to a comfortable level.\u00a0<\/span><\/p>\n But there are a couple of real constraints that make things more complicated. Unfortunately, some of these constraints are at odds with each other.\u00a0<\/span><\/p>\n Let\u2019s talk about two things the Fed doesn\u2019t like to discuss publicly.\u00a0<\/span><\/p>\n The first is the risk of stagflation. You\u2019ve probably heard this term, but for those who haven\u2019t, it\u2019s essentially a situation where we have both inflation and a recession.\u00a0<\/span><\/p>\n Inflation is typically a sign of a strong economy, but uncontrolled inflation can create a downward spiral that can destroy the economy for years or decades.<\/span>\u00a0<\/span><\/p>\n An excellent example of this is Japan in the 1990s and 2000s. In 1991, the Japanese government spiked rates to curb inflation, popping their economic bubble.<\/span><\/p>\n This plunged Japan into a low growth, high inflation environment for the next 20 years called the \u201c<\/span>Lost Decade<\/span><\/a>.\u201d<\/span><\/p>\n So, how do we avoid stagflation?\u00a0\u00a0<\/span><\/p>\n Conventional wisdom says that to avoid stagflation, we need to raise rates quickly, shock the system, quash inflation, and get things back into the normal rhythm.\u00a0<\/span><\/p>\n Many people have suggested that this is the right move for the Fed to make at this time. Even if it plunges us into recession, it\u2019s better than risking a spiral into stagflation, which could be a much worse and longer-lasting economic downturn.\u00a0<\/span><\/p>\n This brings us to the second constraint that we\u2019re facing in this current economic crisis that makes things complicated.<\/span><\/p>\n When we raise interest rates, bond yields (the interest paid to bondholders) rise. Since Treasury bonds are simply debt that the U.S. creates, raising interest rates means we need to pay more interest on our national debt. Just like when we take a mortgage on a rental property, the higher the interest rate, the harder it is to cash flow due to the higher interest payments.\u00a0<\/span><\/p>\n When interest rates and bond yields rise, the government spends more money on interest payments. This means we either have to borrow more money (again at the higher interest rate) to pay all that interest, or we need to spend less money on items such as welfare, defense, education, infrastructure, and other programs.\u00a0<\/span><\/p>\n\n
Stagflation<\/h2>\n
![\"japan's](\"https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2022\/05\/Screen-Shot-2022-05-20-at-10.42.15-AM.png\" "\\"Our")
<\/source><\/source><\/picture>Raising rates too high too quickly could cause an irreversible debt crisis.\u00a0<\/span><\/h2>\n
![\"US](\"https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2022\/05\/Screen-Shot-2022-05-20-at-10.48.15-AM.png\" "\\"Our")
<\/source><\/source><\/picture>