The era of near-zero interest rates is likely over. Families are adjusting. Now Washington must, too.
Congress and the White House are not prepared for a world with higher interest rates, and there's no backup plan.
W eary families have already seen soaring inflation reduce their real wages by 3 percent over the past year. The Federal Reserve and market forces will likely defeat inflation within a reasonable time frame. But the resulting higher interest rates will cost Washington — and taxpayers — for many years to come.
Any family shopping for a new home is already feeling the interest-rate crunch. Since last year, the average mortgage rate on a conventional fixed-rate loan has jumped from 2.6 percent to 5.8 percent, pushing up the monthly payment on a median-priced home from $1,289 to $1,877. Interest rates on car loans and small-business loans have jumped as well.
Rates are likely to continue rising. The Federal Reserve has quickly hiked the federal funds rate from 0.25 to 1.75 percent, yet will likely have to go higher to crush inflation. And once inflation is defeated, a more vigilant Fed is unlikely to drop rates back within the 0–2.5 percent range that has prevailed over the past 14 years.
Investors will likely demand many years of higher interest rates and an inflation risk premium to avoid getting burned again. Such a scenario helped drive up 1980s interest rates in response to 1970s inflation. Other factors that may drive up interest rates for years to come include a long-awaited productivity surge (which would increase borrowing by making capital investments more profitable, and families more willing to borrow against future wealth), global investors chasing stronger returns in faster-developing economies, and baby boomers finally spending down their decades of retirement savings. The colossal national-debt surge projected by the Congressional Budget Office would add approximately three percentage points to interest rates over three decades.
Washington, perched for now on top of a mountain of debt, can ill afford higher interest rates. For the past few years, short-sighted lawmakers, economists, and columnists have demanded that Congress take advantage of low interest rates by engaging in a massive borrowing spree. Indeed, President Biden’s enormous spending agenda was often justified by the low interest rates on government borrowing.
This case never made sense for two reasons. First, Washington was already projected to add $100 trillion in baseline deficits over the next three decades due primarily to Social Security and Medicare shortfalls. Even with low rates, interest costs were projected by the CBO to become the most expensive item in the federal budget and consume half of all tax revenues within a few decades. Additional borrowing would deepen the hole.
Second, Washington never locked in the recent low interest rates. In fact, the average maturity on the federal debt has fallen to 62 months. If interest rates rise at any point in the future, nearly the entire escalating national debt would roll over into those rates within a decade. Consequently, continued federal borrowing means gambling America’s economic future on the hope that interest rates never rise again. And there is no backup plan if rates do rise.
We are now getting a taste of the cost of higher interest rates. The latest CBO budget baseline conservatively assumes that the average interest rate on the federal debt rises to 3.1 percent over the decade, which is just 0.7 percent above what it projected last year before inflation and interest rates began growing. Even that modest forecast shows that, a decade from now, the $1.2 trillion cost of annual federal interest payments will exceed the defense budget, and represent a record 3.3 percent of the economy. And that is the rosy scenario of a strong economic recovery, low inflation, no new spending expansions, and the 2017 tax cuts expiring on schedule.
And what if interest rates surpass the CBO’s projected 3.1 percent rate a decade from now? Each additional percentage point would cost the federal government $2.6 trillion over the decade, and $400 billion annually by 2032. That $2.6 billion would far exceed the cost of the 2017 tax cuts, and approach the cost of President Biden’s proposed Build Back Better extravaganza. It would be enough money to double federal spending on veterans’ health care as well as highways and transit, and still offer families a $300 annual tax rebate. Instead, it will merely go to pay bondholders.
And that is all from just one percentage point in higher interest rates. If interest rates instead rise by two percentage points over the baseline, it would bring $3 trillion annual budget deficits within a decade even with peace, prosperity, and no new federal initiatives.
The long-term cost is even more dire. Over the next three decades, interest rates exceeding the CBO projection by even one percentage point would add $30 trillion in additional interest costs — which is the equivalent of funding an additional Department of Defense. Within three decades, interest would consume 70 percent of annual taxes, drive budget deficits to 18 percent of the economy, and push the national debt to nearly 250 percent of the economy. Additional rate increases would produce dramatically worse results.
Congress and the White House are not prepared for a world with higher interest rates. Basic financial risk management means selling longer-maturity bonds to lock in the current interest rates whenever there is a notable risk of higher future rates. Lawmakers must also stop digging the hole deeper with expensive new legislation, and gradually close the Social Security and Medicare shortfalls driving long-term deficits. Any austerity should be imposed gradually to maintain economic growth and the tax base.
The era of near-zero interest rates is likely over. Families are adjusting. Now Washington must, too.