This time, higher rates are boosting spending and the economy

Higher interest rates are supposed to slow the economy. What if they're helping it instead?

The idea is so radical that it borders on heresy. But as the US economy hums along, confounding experts who'd warned of an imminent downturn, more investors are willing to at least entertain the fringe economic model the disciples of Modern Monetary Theory have championed.

The contrarians—who now include such prominent figures as hedge fund manager David Einhorn and BlackRock Inc.'s bond guru Rick Rieder—argue that the jump in interest rates to more than 5% from almost 0% over the past two years is giving Americans a significant stream of income from their bonds and savings accounts for the first time in two decades. "The reality is people have more money," says Kevin Muir, a former derivatives trader who writes an investing newsletter called the Macro Tourist. These people—and companies—are in turn spending a big enough chunk of that newfound cash, the theory goes, to push up demand and sustain growth.

In a typical rate-hiking cycle, the additional spending from people and businesses that receive interest isn't nearly enough to match the drop in demand from those who stop borrowing money because higher rates make taking out mortgages and issuing bonds more expensive. These factors cause the classic Fed-induced downturn (and, in theory, a corresponding drop in inflation).

But it's different this time for a few reasons, the contrarians argue. Principal among them is exploding US budget deficits: The additional interest the government has to pay on its debt puts more money in the pockets of American (and foreign) bond investors. In April alone, the interest payment totaled $102 billion, more than double the amount a decade ago.

Greenlight Capital's Einhorn, one of Wall Street's best-known value investors, says US households receive interest on more than $13 trillion of short-term assets, almost triple the $5 trillion in consumer debt, excluding mortgages, on which they have to pay interest. (Many Americans managed to lock in ultralow rates on their 30‑year mortgages during the pandemic, shielding them from much of the pain that rising rates have caused.) At today's rates, that difference translates to a net gain for households of about $400 billion a year, Einhorn estimates.

Another important change is the demographics. As baby boomers retire, the elderly have become the biggest driver of US consumption. Although higher interest rates hurt low-income borrowers, they enrich the retirees, who tend to have the most savings and who account for more than 20% of consumer spending, says BlackRock's Rieder.

In a corollary to the rate-hikes-lift-growth theory, there's the idea that rate cuts might push inflation down, not up, because they'd reduce the income and spending. "People are spending—older people, middle- to high-income are spending—and are keeping that service-level inflation at high levels," Rieder said in an interview on Bloomberg Television. "I would lay out an argument that, actually, if you cut interest rates, you bring down inflation."

To be clear, most economists and investors still firmly believe in the age-old principle that higher rates choke off growth. As evidence, they point to rising delinquencies on credit cards and auto loans and to how job growth, while still robust, has slowed. Mark Zandi, chief economist at Moody's Analytics, spoke for the traditionalists when he called the new theory simply "off-base." But even Zandi acknowledges that "higher rates are doing less economic damage than in times past."

Disclaimer: This article first appeared on Bloomberg, and is published by special syndication arrangement.