Interest Rates and the Fallacy of Historical Trends
With inflation at its highest level in 40 years and interest rates rapidly rising, the heavily indebted U.S. government is likely to experience a period of growing fiscal stress
By Jack Salmon and Veronique de Rugy
One of us is so old that she has been predicting a fiscal crisis for decades. Needless to say, until now she has been wrong. In her defense, it’s not as if American legislators’ uncontrollable addiction to deficit spending hasn’t already exacted a terrible cost in terms of lower growth and other economic distortions. Still, she has to admit, so far, there has been no debt crisis.
Having said that, if the surge in inflation over the past 18 months has taught economists anything, it should be this: that trends can change, and sometimes trends can break altogether.
Let’s start at the beginning. One key reason for our mistakes about the likelihood of a fiscal crisis is rooted in our failure to account for the trend of declining interest rates over time. Low rates mean a better ability to handle the interest paid on our debt and a delay in the worst of its consequences. In fact, thanks to low interest rates, payments on the federal government debt as a share of GDP have fallen from over 3% in the early 1990s to 1.5% in 2021.
What caused this incredible decline in interest rates is debatable. Some say it’s due to demographics; others say increased globalization is the reason. Some point to the actions of the Federal Reserve; others say it’s the savings glut and the insatiable appetite of foreigner investors for U.S. government debt. Hoover Institution economist John Cochrane, however, believes the main driver of the four-decade decline in interest rates is the decline of our economic growth rate. What role did our excessive spending and growing debt play in the declining growth? That is another question for another time.
Nevertheless, after 40 years of false warnings about an upcoming fiscal crisis from small government advocates and after what looked like an absolute defeat of inflation, no one was ready for the current moment. If interest rates were to remain low into the foreseeable future, why not accumulate more debt? That’s exactly what the federal government did.
In recent years, politicians were encouraged by economists who, while they initially failed to foresee the decline in interest rates, became extremely confident that interest rates would remain at historically low levels into the foreseeable future and that we had once and for all conquered inflation, especially in the aftermath of the financial crisis of 2007-2008. The list of these believers is too long to recount. However, a few economists stand out, in part because they offered interesting theories about why low interest rates meant we shouldn’t worry about the debt.
French economist Olivier Blanchard made the case in 2019 that increased borrowing and a larger public debt incur no fiscal costs because the interest rate on debt servicing has historically been below the growth rate of the economy. Basing this zero fiscal cost claim on historical trends, Blanchard argued:
If the future is like the past, this implies that debt rollovers—that is, the issuance of debt without a subsequent increase in taxes—may well be feasible. Put bluntly, public debt may have no fiscal cost.
In a similar vein, economists Larry Summers and Jason Furman published a paper in 2020 on fiscal policy in an era of low interest rates. The authors noted that “at current and prospective interest rate levels, nominal and real Federal debt service is likely to be low not high by historical standards over the next decade.”
To their credit, these three were also the ones to foresee early on that inflation was coming, fueled by excessive government spending during the pandemic, due in part to their impeccable Keynesian credentials. Indeed, the only mystery is that so many other economists failed to see it. After all, when the American Rescue Plan (ARP) was adopted in March of 2021, the output gap (the difference between the economy’s actual economic output and its potential output) for 2021 and 2022, when most of the spending would take place, was $700 billion.
Given that the law appropriated almost $2 trillion, its adoption was bound to lead to overheating. Furthermore, this was made that more obvious by the fact that the ARP came on the heels of $3 trillion in COVID spending the year before and at a time when the economy was still fairly closed and supply constrained. Finally, ARP arrived after the unemployment rate had dropped from 14% the year before to only 6%, further flooding the economy with cash from a larger workforce.
Also worth noting, these economists believed that there were some limits to their theories. Furman and Summers, for instance, say in their 2020 paper that governments should continue expansionary fiscal policies so long as the real interest rate (represented by 10-year yield minus inflation) remains below 2% of GDP. While this was a healthy nod toward reality, it did not go far enough. Indeed, as we wrote earlier this year, there were additional limitations of their theories.
With inflation at a four-decade high, the Federal Reserve is currently engaged in the most aggressive monetary tightening program since the mid-2000s, putting upward pressure on interest rates. The Federal Reserve Bank of Atlanta expects the effective federal funds rate to peak at 4.5% in March next year and remain above 3.5% through 2024.
In reaction to a higher federal funds rate, interest rates on Treasury yields have increased significantly since the start of the year. The yield on the 10-year Treasury is currently sitting at around 4%, while the 3-year Treasury yield is around 4.35%. These numbers are important because 51% of all U.S. Treasury debt is held in maturities of three years or less. What’s more, the average interest rate on marketable Treasury debt (debt issued to raise money to finance government expenditure or pay off maturing debt)—meaning any theoretically liquid short-term bond issued by the government and held by investors in lieu of cash—has risen from 1.56% at the start of the year to 1.97% in August.
With this upward trajectory in debt servicing costs, it is likely that in fiscal year 2023 interest payments on the national debt will outweigh total defense spending for the first time in history. As the Treasury rolls over its sizable debt pile, the average interest rate on servicing the debt is beginning to explode higher. As of August, monthly debt servicing costs reached $63 billion—this is double the average monthly cost in 2019 and equal to total government defense expenditures in the same month.
Using the Congressional Budget Office interactive budget tool, we can get some idea of the scale of the additional debt-servicing costs caused by higher than anticipated interest rates. If the interest rate on the 10-year Treasury note is 0.5 percentage points higher than expected in the coming decade, the cumulative budget deficit during the same period will be $1.43 trillion larger than the baseline projects. If the interest rate is 1 percentage point higher than expected, the cumulative deficit will be $2.85 trillion larger over the decade.
These are large, unplanned expenses for which we have no money. It means more borrowing and added pressure on inflation and interest rates. But this could be only the beginning. It is clear at this point that the Federal Reserve will have to raise interest rates more since, up to this point, its rate increases have failed to tame inflation. In the coming years, it is possible that servicing costs could reach 3% of GDP—notably larger than the current cost of funding Medicaid.
In its September meeting, the Federal Open Markets Committee (FOMC) of the Federal Reserve released its summary of economic projections. The FOMC forecasts that the federal funds rate will peak at 4.6% next year and decline slowly to 3.9% in 2024. However, as with any economic projection, we should take these estimates with a large grain of salt. The FOMC is constantly revising up both its inflation and federal funds rate projections. Only six months ago the FOMC was projecting a peak federal funds rate of just 2.8%.
Finally, as unsettling as it is for economists who are so attached to their predictions and models, the truth is that no one knows how much interest rates will need to be raised to anchor inflation back to its 2% target. Will the Fed need to raise interest rates above the inflation rate—which currently stands at 8.3%? Will a slow and moderate increase suffice? We believe that rates will probably need to go up much more than scheduled and that a soft landing was never in the cards. But we could be wrong. Either way, we will know soon.
The low interest rates of the last decades have postponed the consequences of the government’s profligate spending and, consequently, the enormous accumulation of debt that has occurred since the beginning of the century. That said, it is about to get worse under the weight of unfunded programs like Social Security, Medicare and Medicaid. If the current increase in interest rates continues, these consequences, which may include a serious fiscal crisis, could happen faster than we thought was ever possible, even a year ago.