Economy & Business

Higher Interest Rates Could Explode Budget Deficits and Our National Debt

Fiscally responsible deficit reduction is more important now than ever before.

The Federal Reserve is expected to raise the target interest rate next week, continuing its long climb back to traditional levels. While the economic impact of rate hikes is intensely debated, less attention has been focused on the extraordinary impact they will have on federal spending and the national debt.

The short answer is that higher interest rates can cost taxpayers trillions of dollars.

The budget outlook is already perilous: After gradually declining since 2010, annual budget deficits are projected by the Congressional Budget Office (CBO) to soar past $1.4 trillion a decade from now, and then keep growing thereafter. And that is the rosy scenario; it assumes no recessions, wars, terrorist attacks, tax cuts, or federal spending expansions.

It also assumes only modest interest rate increases, which is important given that the national debt already sits at $20 trillion and is slated to increase by another $10 trillion over the next decade. CBO estimates that each one-point rise in interest rates adds $1.6 trillion to the ten-year budget deficit — $262 billion of which comes in the tenth year, as costs accelerate. Thus, a four-point interest-rate hike would cost taxpayers $6.4 trillion over the decade, and more than $1 trillion in the tenth year alone — far more than the cost of defense or Medicaid spending.

Fortunately, interest rates have remained low. Because of the Federal Reserve’s policies and the sluggish economy, the average interest rate paid on the ten-year Treasury bond (which is similar to the average interest rate Washington pays on its debt) is currently 2.4 percent, and is projected by CBO to rise to just 3.6 percent in a decade. By comparison, the average interest rate was 10.5 percent in the 1980s and 6.6 percent in the 1990s. Even in the 2000s, which ended with a massive recession that collapsed interest rates, the rate averaged just 4.5 percent.

But now, CBO’s rosy assumption that rates will remain low seems mistaken.

First, the Federal Reserve is expected to continue phasing out its policy of keeping interest rates extraordinarily low, meaning rates should normalize over the next few years.

Second, interest rates have been constrained by the weak recovery that followed the Great Recession. If the economy eventually returns to its more typical 3.0 to 3.5 percent growth rate, demand for business, auto, and home loans should go up, thus raising interest rates.

Finally, and most importantly, the soaring national debt will eventually push interest rates significantly higher, because added demand raises prices. With the national debt in the process of rising $20 trillion over 20 years, all of Washington’s new borrowing represents a historic increase in the demand for savings, resulting in higher interest rates for the government (as well as for families and businesses).

Up until now, the Federal Reserve and the weak economy have counteracted the interest effects of this new debt, saving taxpayers $1.3 trillion in lower national-debt-interest payments since 2009. But as the Federal Reserve tightens its policies, economic growth (hopefully) picks up, and the national debt continues surging, all signs suggest interest rates will be significantly higher down the road.

The effect this has on the budget could be enormous. If interest rates merely return to 1990s levels, the resulting costs would raise the 2027 budget deficit from $1.4 trillion to $2.2 trillion. And if the large increase in government borrowing somehow brings back the 10.5 percent interest rates of the 1980s (unlikely, but not impossible), the annual budget deficit would approach a staggering $3.2 trillion a decade from now.

At that point, interest on the debt would cost $2.5 trillion per year, or $17,000 per household — nearly as much as Social Security and Medicare spending combined.

This should give pause to any lawmakers seeking large tax cuts or spending increases. A $1.4 trillion deficit within a decade is risky enough, and deficits of $2 trillion or $3 trillion would be economically catastrophic. Perhaps the CBO is correct that interest rates will remain historically low, but it would be irresponsible to bet the economy on that assumption. Instead, responsible deficit reduction can ensure that future generations are spending their tax dollars on their priorities, rather than making cataclysmic interest payments on earlier expenditures they never voted for.

 — Brian Riedl is a senior fellow at the Manhattan Institute. Follow him on twitter @Brian_Riedl.

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