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Federal Debt When Interest Rates Rise

By News Creatives Authors , in Business , at October 16, 2021

When interest rates rise, how much will the interest cost of the federal debt increase? The Federal Reserve is increasingly talking about tapering its efforts to keep long-term interest rates low, the latest being the minutes from their September 2021 meeting. After ending their purchases of long-term securities, they are likely to raise short-term interest rates. When they are in a hurry to shift the economy, they move short-term interest rates by three percentage points in a year. The timing of an interest rate increase is uncertain, but the likelihood of an increase in the next couple of years is nearly certain.

The federal government has about $22 trillion of debt held by the public. (Some of its debt is held in government trust funds, such as for Social Security, so interest is both an expense and an income to the government.) Last year interest on the debt came to $413 billion, with a low average interest expense of about 1.5%. (Calculation of average interest is complicated by floating rate debt and inflation-adjusted debt as well as the timing of debt issuances and maturities. This is ballpark estimate.)

What would happen if interest rates rose by, say, three percentage points for both short-term and long-term interest rates? The short answer will sound like it is coming from a proponent of bigger spending: not too much. But the “not too much” answer comes in the context of trillion dollar deficits, with more on the way. It turns out that interest expense is not the big item that the United States needs to worry about.

The maturity of federal debt ranges from next week to 2051. Thirty percent is due within the next 12 months, with another 13% in the following 12 months. It’s a great puzzle why, in an era of historically low interest rates and projections of high future deficits, the U.S. Treasury did not lock in low interest rates by issuing more long-term debt and less short-term paper. Whatever the reason, our hypothetical increase in interest rates will boost net interest expense on 43% of the debt in the next two years, adding about $240 billion to federal outlays. (The exact amount depends on the timing and maturity schedule of new debt issuance.) Let’s round that to a quarter of a trillion dollars. That’s real money but small compared to our overall outlays, especially small after Congress passes multi-trillion budget reconciliation and infrastructure bills.

The rest of the world won’t shun American debt, despite what looks like an irresponsible level of borrowing. International investors are not asking themselves, “U.S. debt, yes or no?” Instead, they are asking themselves, “U.S. debt or Chinese debt or French debt or Brazilian debt or …?” In this context, we look pretty good. Global investors may diversify their assets across multiple countries but are unlikely to avoid our securities. That means we will not have to pay a premium interest rate to borrow money.

Some people wonder if the Federal Reserve will really push interest rates up, given that they own so much in bonds. Rising interest rates mean a fall in bond prices, so the Fed would have a loss on the securities it bought. However, the Fed is not at all motivated by profit and loss of its own operations, and certainly not for paper losses. And the treasury bonds will all be paid off in full—even if the Treasury has to issue new bonds to pay off the old ones.

The current interest rate expense is not a huge burden relative to the size of our total federal revenues and outlays, but that does not mean the current trajectory is sustainable. Eventually excessive borrowing catches up with the spendthrift. We cannot know exactly when that day will come. It’s unlikely to be in the next few years, but it certainly will come if the U.S. fiscal house does not get in order.

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