Higher Interest Rates Will Raise Interest Costs on the National Debt

Dec 14, 2016

Today, the Federal Reserve increased its target for the federal funds rate by another 25 basis points. In her statement, Fed Chair Janet Yellen said,

Today the Federal Open Market Committee decided to raise the target range for the federal funds rate by .25 percent, bringing it to .50 to .75 percent. In doing so, my colleagues and I are recognizing the considerable progress the economy has made toward our dual objectives of maximum employment and price stability. Over the past year, two and a quarter million net new jobs have been created, unemployment has fallen further, and inflation has moved closer to our longer run goal of 2 percent. We expect the economy will continue to perform well, with the job market strengthening further and inflation rising to 2 percent over the next couple of years.

The Federal Reserve last raised the federal funds rate in December 2015. That was after a lengthy period of holding the federal funds rate close to zero in an effort to help the economy recover from the financial crisis.

The continued tightening of monetary policy should be viewed as a positive sign of economic strength. The economy has strengthened considerably since the depths of the recession, and the Federal Reserve’s actions reflect these improvements.

Going forward, there will be a number of consequences of a gradual increase in the federal funds rate over time. In the private sector, interest rates on everything from car loans to home mortgages to business loans will rise. Interest rates on government securities will also rise — meaning that the federal government will have increased borrowing costs, which will have significant consequences for our national debt.

Under current law, CBO projects that net interest costs will more than double over the next 10 years, soaring from $270 billion in 2017 to $712 billion in 2026 and totaling $4.8 trillion over the period. 1 Interest costs are expected to continue climbing beyond the next 10 years and are projected to be the third largest category in the federal budget by 2028 (after just Social Security and Medicare), the second largest category in 2046, and the single largest category in 2050.

Ballooning interest costs threaten to crowd out important public investments that can fuel economic growth in the future. In its most recent long-term budget report, CBO estimates that by 2046, interest costs are projected to be more than double what the federal government has historically spent on R&D, nondefense infrastructure, and education, combined.

The long-term fiscal challenges facing the United States are serious. Even though our current deficits are lower than they used to be, we are still adding an average of more than one billion dollars to our national debt load every day. Worse yet, we are headed toward a period of rising demands from unfunded entitlements in a rapidly aging society, combined with a tax system that fails to raise enough revenue and is filled with inefficient and costly tax subsidies. Many economists warn of this growth in debt — this year, both GAO and Ernst & Young also released reports this year warning about the dangers and unsustainability of U.S. fiscal policy.

To be clear, the culprit here is failed fiscal policy, not our monetary policy and the Federal Reserve. Congresses and presidents of both parties, over many years, have avoided making hard choices about our budget and failed to put it on a long-run, sustainable path. In recent years, many have said that the fragile nature of the recovery meant that it was not the right time to take fiscal action. Now, as the economic recovery continues to take hold, we have the opportunity to put in place sensible and gradual reforms that will put our long-term fiscal trajectory on a sustainable path.

1 Under current law, CBO projects that interest rates on 3-month Treasury Bills will increase from 0.3 percent in 2016 to 2.8 percent in 2026, while interest rates on 10-year Treasury Notes will increase from 1.8 percent in 2016 to 3.6 percent in 2026. The interest rates are expressed as calendar-year averages. ( Back to citation)


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