September 2, 2014

As Interest Rates Begin to Normalize, How High Will Interest Payments Climb?

Chad Laurie is an intern at The Concord Coalition.

Historically low interest rates, held down by the Federal Reserve’s quantitative easing program, have recently begun to rise sharply. Over the past few weeks, the interest rates on the federal debt rose 67 basis points from 1.66 percent to 2.33 percent. The increase is on pace with what the Congressional Budget Office projected in its most recent budget outlook; CBO estimates there will be $223 billion in net interest payments this year. In that same outlook, the CBO’s baseline assumes an increase in interest rates due to a recovering economy, and projected that interest payments on the federal debt would be $823 billion, or 3.2 percent of GDP in 2023, a percentage that has been exceeded only once in the past 50 years. With rates approaching levels consistent with a growing economy, interest costs will be the fastest growing spending program in the federal budget.

Why Were Rates So Low and Why Are They Rising Now?

During and after the recession, the Federal Reserve bought mortgage-backed bonds and Treasury securities to make borrowing cheaper for consumers and the government until the economy could fully recover. Additionally, investors looking for a safe haven invested heavily in Treasury securities, further lowering the government’s cost of borrowing. This allowed consumers and the government to borrow at record low rates for the past several years.

Recently the economy has continued to improve, adding 175,000 jobs in May, evidence that investors have begun to regain confidence and are pulling their money from Treasury securities to invest in the private sector. Due to the positive economic news, the Federal Reserve has indicated it may start reducing bond purchases, which has influenced bond investors to anticipate higher interest rates, which itself has caused interest rates to rise.

As the economy strengthens and interest rates return to normal levels, interest payments on the debt will increase substantially over the next 10 years, even with projected increases in revenues, decreases in health care costs and spending caps for discretionary spending. Despite all the celebrating in Washington about decreasing the deficit for the next few years, the recent increase in Treasury yields shows that government borrowing costs could still rise substantially. The CBO has already projected an exponential increase in interest payments over the next 10 years due to rising interest rates. Rising rates will mean fewer budgetary resources for programs that have already faced substantial cuts. The recent rise in interest rates signals an economic recovery, but also offers a reminder that the federal government must control its borrowing to hold down its interest payments and protect itself from volatile interest rates. That will require a comprehensive plan that addresses the long-term trajectory of federal budget shortfalls. The solutions will not be simple, but the consequences of inaction will be far worse for the recovering economy and the country.