The US in the financial year ending 2006, paid over $400 billion in interest on debt ! Following the 14 consecutive Fed rate what will happen when the debt needs to be reissued at these higher interest rates ? I.e. average debt maturity is less than 60 months with total US debt stands at $8 trillions. Thus interest payments are likely rise substantially in the coming years whilst at the same time the US is running an record annual budget deficit of over $500 billion.

So what can the Federal Reserve do to extricate the US from this developing crisis ?

In two words - Print Money!

The evidence of the printing presses running at full steam are the measures of Money, i.e. M3, currently running at over 8%. The effect of printing money is to increase inflation and devalue the dollar, this reduces the value of the debt AND interest payments. Which suggests that interest rates are likely to fall even with rising inflation as the US moves to higher inflation rate in an attempt to service the debt and to gradually erode its value.

This does not bode well for foreign debt holders who own nearly half of the US debt, because as the dollar falls the value of the debt decreases. This could at some point lead to panic selling amongst debt holders which would result in a crash in the dollar and the US forced to raise interest rates to prevent hyper inflation.

The plan seems to be for a gradual erosion of the debt, some possible ways are by employing negative interest rates as the US did following Sept 11th, when interest rates were less than the inflation rate. Current US inflation rate is 3.82%, with interest rates at 5.25%. These two rates are likely to converge during 2007, a culmination of a cut in US interest rates whilst US inflation rises to above 4%. Should inflation fall, i.e. in response to a slowing US economy, then we could see significant cuts in interest rates during 2007 to below the rate of inflation.

(c) MarketOracle.co.uk 2005-2006

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