Soaring interest rates mean debt reckoning could come years sooner than thought

Alfaro Recoba

Interest rates have exploded over the past several months, threatening to raise dramatically the cost of servicing the federal debt and accelerate a fiscal reckoning.

Yields on 10-year Treasury securities soared to above 3.8% as of Friday evening, up from about 1.5% at the start of the year and the highest since 2010.

The surge comes after years of ultralow interest rates that have allowed the federal government to incur massive amounts of debt, especially during the coronavirus pandemic, with little repercussion. The federal debt held by the public has skyrocketed in recent years, from around $17 trillion pre-pandemic to above $24 trillion, but the cost of servicing the debt has stayed low, thanks to the ultralow interest rate environment.

That is now changing quicker than forecasters had imagined. The nonpartisan Congressional Budget Office, in its latest projections, had not expected interest rates on 10-year Treasuries to reach the 3.8% seen Friday until 2028. Professional forecasters surveyed by the Federal Reserve Bank of Philadelphia projected in the first quarter, before the Fed began raising its interest rate target to curb inflation, that 10-year Treasury yields would average 3% over the next decade.

The higher interest rates will rapidly raise the borrowing costs for the government as it is forced to issue new debt with higher rates.

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Because federal debt is relatively short-term, the Treasury has to offer new bonds frequently, meaning that borrowing will be more expensive as rates rise.

Mark Warshawsky, a senior fellow at the American Enterprise Institute, told the Washington Examiner that the best way to look at the situation and how it could affect the budget deficit down the line is to make a reasonable guess about what the interest rate will be for this year and into 2023 and analyze potential debt through that lens.

Warshawsky, emphasizing that these are extremely rough numbers with a high degree of uncertainty, said that if, for example, interest rates increase to 5% into next year, the increase in the federal deficit from baseline expectations would be enormous — about $500 billion more added to the annual deficit.

Already, net interest rate costs were projected to rise to nearly equal all nondefense discretionary government spending by the end of the decade, according to the CBO. Higher interest rates would mean Uncle Sam would spend much more just servicing the debt than on all the other domestic spending that Congress votes for.

The higher deficits and debt, in turn, would be expected to translate to higher interest rates — the government would have to borrow more, meaning it would have to offer higher interest rates to entice more buyers.

“We’re at the risk of a bad cycle for the deficit and for the economy,” Warshawsky said. “As the deficit goes up and as the debt outstanding goes up as a percent of GDP, I think everyone agrees that interest rates go up.”

In response to an inquiry from Rep. Jason Smith (R-MO), the CBO said in August that each increase in federal debt of 1% of gross domestic product raises interest rates by 2 to 3 basis points. Thus an increase in federal debt of 10% of GDP would boost interest rates by about one-quarter of a percentage point

“Over time, additional debt could lead to increased concerns by market participants that the U.S. government would allow high inflation to erode the real value of the debt,” the CBO report read. “Ultimately, such concerns could lead to a fiscal crisis in which interest rates rose markedly as market participants required higher compensation to lend to the Treasury.”

In its August response to Smith, the CBO also acknowledged how, between July 2021 and May of this year, it raised its interest rate and inflation projections, boosting net interest outlays from 2022 to 2031 by an additional $1.7 trillion.

Warshawsky said the CBO’s most recent rule-of-thumb forecast also didn’t anticipate a severe stock and bond market downturn, which he said also has an effect on the deficit.

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“That affects tax revenues pretty profoundly because a lot of tax revenues come from capital gains, so that’s also an impact on the deficit in the upcoming year, which was not in the CBO forecast,” he said.

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