Rising Interest Rates Will Increase Federal Budget Challenges

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Last week brought some good news for the economy and challenging news for the federal budget.

The good news was a solid jobs number — a gain of 200,000 in January — and an even more promising gain in average hourly wages to 2.9 percent from a year earlier. Combined with steady, if unspectacular, growth of 2.6 percent at an annual rate in the fourth quarter of 2017, the economy seems to be doing pretty well.

Now for the challenging budgetary news. The interest rate on 10-year Treasury bonds hit 2.8 percent on Friday, not high by historical standards but the highest level in four years.

For the federal budget, that means the period of low-cost borrowing might be coming to an end. Higher interest rates mean higher costs of servicing the debt. That, in turn, means higher deficits and a more difficult path to fiscal sustainability.

This has been a looming problem as the federal government took on huge new levels of debt at very low interest rates to combat the 2008-09 recession and its aftermath.

In June 2017, the Congressional Budget Office (CBO) projected that interest costs would rise from $269 billion in 2017 to $818 billion in 2027. Over that time the cumulative interest cost would exceed $5.6 trillion.

Those numbers, however, are likely to go up when the CBO updates its projections in the coming weeks based on changes to two key variables which came into better focus last week.

The first is the size of the national debt on which the government is paying interest. That is going up as a result of the tax cuts enacted in December. The Treasury Borrowing Advisory Committee (TBAC) estimated last week that the federal government’s borrowing needs would be $955 billion this year and more than $1 trillion in 2019 and 2020. That would be roughly twice the size of the $519 billion in net borrowing required in 2017.

The second variable is the interest rate, which determines how much the government must pay for each dollar of outstanding debt.

In June, the CBO assumed that the interest rate on 10-year Treasury bonds would reach 2.7 percent by the end of September. With that rate hitting 2.8 in early February, the supply of government debt going up and the economy continuing its expansion, there is good reason to believe that interest rates will climb higher as the government competes for investment dollars.

Over the next decade, CBO projections are for the interest rate on 10-year bonds to rise to around 4 percent. And if interest rates are just one percentage point higher than projected, federal interest payments would be around $1.5 trillion higher through the next 10 years. That’s almost enough to pay for the entire military budget for three years.

The worst situation would be one in which growing debt and rising interest rates feed into a vicious cycle. Lenders could demand higher interest rates to compensate for concerns about the unsustainable debt. The resulting higher interest costs would be paid with additional borrowing, which would lead to more debt and further increases in interest costs.

Even if this worst-case scenario never came to fruition, rising interest rates could still result in ballooning interest costs that crowd out other critical federal investments as they compete for limited resources.

To be clear, rising interest rates are not a cause for panic. They are a sign of life in the economy and are still far below the 1990s average of about 6.7 percent. They should, however, serve as a fiscal responsibility wake-up call. Debt is getting more expensive. It is thus critical that policymakers protect the nation from rapidly rising interest rates by controlling the growth of the nation’s debt burden.

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