The U.S. government’s fiscal landscape is undergoing a seismic shift, one that is not originating in Capitol Hill but rather in global bond markets. The rapid increase in long-term interest rates has created a situation where the U.S. government is poised to spend significantly more on interest payments than previously anticipated. This shift has major implications for the nation’s fiscal health, with profound consequences for taxpayers, government services, and the overall economy.
Interest Costs on the Rise
An upward shift in long-term interest rates is driving the U.S. government’s interest bill to new heights. If current rates remain elevated and fiscal policy aligns with current forecasts, the cost of servicing the national debt is projected to surpass defense spending in 2025 and even exceed Medicare spending in 2026. The numbers from the Committee for a Responsible Federal Budget are alarming, estimating that interest spending will exceed $800 billion in the current fiscal year, more than double the figure from 2021. By 2026, the government’s net interest expense is predicted to reach 3.3% of GDP, the highest on record.
Changing Assumptions and Consequences
A significant factor contributing to this fiscal challenge is the change in assumptions about interest rates. In July, the Congressional Budget Office (CBO) projected that the 10-year U.S. Treasury bond would yield 3.8%, reflecting the rates at that time. However, since then, the 10-year yield has surged, surpassing 4.8% on October 6. This shift has led to higher interest costs for the government.
The Burden of Old Debt
The burden of old debt is becoming more onerous as longer-term Treasury securities issued during the low-rate era gradually mature. These maturing securities are being replaced by new debt at significantly higher interest rates, making the rollover of debt more expensive. For instance, Axios calculations show that $207 billion in Treasury notes, which recently matured, had an average interest rate of 1.2% and will be replaced by debt with an interest rate of around 5%.
Political and Economic Implications
The increase in interest costs poses an open question regarding its impact on the political landscape. For the past 15 years, low-interest rates provided fiscal policymakers with a kind of “free lunch.” Debt service costs remained low as a share of the economy, allowing for substantial deficit spending with seemingly few tradeoffs. However, the era of low-interest costs may be coming to an end, and the political conversation in Washington has yet to fully acknowledge the shift.
The looming high interest expenses may alter the dynamics of fiscal policy discussions. Historically, high interest expenses have forced policymakers to focus on deficit reduction, as seen during the late 1980s and early 1990s. Whether this trend repeats itself will depend on how policymakers respond to the fiscal challenge posed by rising interest rates.
Conclusion
The U.S. government’s fiscal outlook is at a critical juncture, with rising interest rates threatening to reshape the fiscal and political landscape. As interest costs surge, policymakers will face tough decisions about balancing competing priorities, including tax cuts, ambitious spending plans, and deficit reduction. Adapting to this new reality is crucial, and it’s a challenge that will demand careful consideration from all sides of the political spectrum to ensure the nation’s long-term financial health.
