How the Fed's 'higher for longer' rate hikes will squeeze the US government
Even small moves in interest rates can have big impacts on deficits.
That's why the surge in bond yields has fueled concerns over the Federal Reserve and government debt, and what deficit watchers see as a looming crisis spelled out in budget lines.
Earlier this week the yield on 10-year Treasuries (^TNX) surpassed levels not seen in more than 15 years, rising just above 4.8%. While yields fell slightly on Thursday, they remain elevated, holding over 4.5% for nearly two weeks. Their climb accelerated in recent weeks after the Fed signaled it would raise rates once more before the end of the year. Investors are also grappling with signs that the central bank will keep rates higher for longer as the Fed struggles to yank inflation down to its 2% target.
The rapid ascent of bond yields — leaping more than 50 basis points in a month — has grabbed the attention of deficit watchers because of the outsized impact interest rates have on the federal budget.
Interest on government debt is on track to cost $10 trillion over the next decade, according to estimates. In the fiscal year of 2022, American taxpayers spent $475 billion in interest on the national debt. The following year that figure climbed to $640 billion. And as a percentage of GDP, the costs of servicing the debt is projected to rise from 2.4% in 2023 to 3.6% 2033.
While deficit spending can serve as an effective economic strategy, especially to stimulate the economy during a downturn, some experts say higher government debt loads can crowd out other types of spending, causing interest rates to rise, which can have a corrosive effect on economic growth.
The Congressional Budget Office estimated earlier this year that if all interest rates — including those on three-month Treasury bills and 10-year Treasury notes — were 0.1 percentage point higher each year than they are in its forecast, deficits would increase progressively over the next 10 years by amounts that would reach $47 billion in 2033. The cumulative deficit from 2024 to 2033 would increase by $303 billion.
And while interest rates are not excessively high by historical standards, the prior period when rates approached 5% coincided with far less government debt as a percent of GDP, so the debt load was easier to manage.
The last time the US had interest rates and Treasury yields this high the debt-to-GDP ratio was a third of the size, said Andrew Lautz, a senior policy analyst at the Bipartisan Policy Center, a think tank that updates a monthly deficit tracker. "So our debt situation is almost three times ... worse. That is going to make it massively more expensive to handle the current debt burden and significantly increase the cost we pay for it."
Even if the Fed’s next rate hike is the last of the cycle, as forecasts suggest, the costs of paying down government debt will keep increasing, as Washington's new borrowing comes at higher interest rates.
Government estimates of future interest payments paint an onerous picture that experts say could spell an unworkable budget. In 10 years, interest payments are projected to exceed $1.4 trillion annually. That's more than defense spending is expected to cost in that period.
“At some point in the future, if we don’t change something, then it’s unsustainable. It just won’t work," said Mark Zandi, chief economist at Moody’s Analytics.
Interest rates are not astronomically high right now, Zandi said, but what's striking is that rates were previously so low. And in the current economic climate, with GDP growth expected to slow, its unlikely that the US economy can expand its way out of the situation, he said. That puts the onus on the federal government to rethink taxing and spending.
Federal Reserve Chair Jerome Powell holds a press conference in Washington, D.C., Sep. 20, 2023. (Aaron Schwartz/Xinhua via Getty Images)
Marc Goldwein, senior policy director for the Committee for a Responsible Federal Budget, a Washington think tank, pointed to an array of policies to combat Washington's fiscal challenges, including tax reform, raising the retirement age, and changes to immigration policy. "We can't grow our way out of this but growth can help us get out of this," he said.
Emergency borrowing during the initial, chaotic phase of the COVID public health crisis came cheap for the government. The Fed kicked into rescue mode and lowered interest rates to avoid a depression. Inflation wasn't an issue then either. But Goldwein noted that while such investments may have seemed cheap at the time, there wasn't a plan to pay for the borrowed money. That means the government's low-interest debt is rolling over into high-interest debt, in addition to Washington taking on altogether new debt, he said.
The CRFB estimates that nearly 60% of government debt originated when the average interest rate on 10-year Treasury notes was less than 3%. And more than half of all debt will mature in the next three years.
Regarding that low-cost borrowing as a free pass was "a huge error that we are paying for," Goldwein said.
Even as some budgetary hawks sound the alarm, other observers don't see a catastrophe waiting to happen. Nathan Tankus, the research director of the Modern Money Network, a nonprofit that runs educational programs about money and economics, said that dire projections of astronomical interest expenses don't account for the ways those government payments will influence GDP. And if the forecasts are as stark and disastrous as hawks say they are, he said, the budgetary calamity would force the Fed to act, since price stability would come under threat.
Tankus, who is writing a book about the Federal Reserve, also points out that concerns over growing debt payments tied to rising interest rates is a reason to rethink the Fed's limited and in some ways crude toolbox for combating inflation.
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