November 23, 2014

Interest Rates Are Low Now, But for How Long?

This post was co-authored with Louise Mackey, intern from the Washington Ireland Program 

Interest rates are at historically low levels, making borrowing very affordable for consumers -- and the United States government. When it issues debt, the federal government, like any other borrower, pays interest. This is how the government finances its annual budget deficits.

Why are interest rates so low now?

There are two primary reasons. First, during the recession there was less demand for credit. And to combat this, the Federal Reserve brought interest rates down to spur borrowing. Second, in response to the global economic slowdown, investors around the world have been desperate to place their money in a safe haven -- and U.S. Treasuries are still considered the safest investment in the world.

Interest rates are projected to stay at or near historic lows over the next two years as the economy continues to recover. Eventually, though, interest rates will begin to return to normal levels as economic growth puts inflationary pressure on the economy. This normalization of rates will increase the government’s borrowing costs. Those costs will also be going up simply because the government is borrowing more and more money.

Like a consumer who borrows money on a credit card with a variable rate, the government is particularly vulnerable to rising interest rates. That’s because it relies so heavily on short-term instruments, with an average duration of only 63.9 months. Since Washington has failed to lock in today’s low rates for a longer period, interest rates increases could have a dramatic impact on the federal budget in the future.

The Congressional Budget Office (CBO) projects that under a current-law scenario with continued economic growth and a return of higher interest rates, the cost of servicing our national debt -- now 1.4 percent of GDP -- would grow to 2.5 percent of GDP over the next 10 years. That scenario is relatively benign compared to the CBO’s more likely “current-policy scenario” in The Concord Coalition’s Plausible Baseline. In this second scenario, where Congress extends tax cuts and postpones some spending cuts currently written in law (like the sequester, or the doctor payment cuts in Medicare), the federal government would be paying 3.8 percent of GDP in interest costs in 2022. That would be more than the federal government is expected to spend on the Defense Department that year.

The projections in this second scenario assume a strong recovery without a rapid rise in inflation or interest rates. However, interest rates are highly volatile and can spike because of unanticipated economic crises. They can also spike if investors become less convinced that our nation’s leaders will be willing to deal with the long-term fiscal challenges we face. If investors lost confidence, the burden of interests costs on the federal budget could become far greater.

Borrowing costs have a direct impact on the rest of the federal budget. As interest payments on the national debt grow, there will be fewer resources available for other priorities. Add the uncertainty created by potential interest-rate volatility, and it becomes clear that the federal government must control its borrowing. That will require a comprehensive reform package that alters the trajectory of federal spending and revenues over both the short and long term. The solutions are not easy, but the consequences of inaction are far worse for the economy and the country.

Created by The Concord Coalition

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