High Interest Rates are Hitting Federal Debt. A Day of Reckoning Is Coming
Treasury interest rates are hitting a 16-year high. After decades of low rates, that change will have consequences for the federal budget. Those effects are more complicated than they may seem at first, however. In fact, there is reason to believe the long-term result will be positive for both the government budget and the economy as a whole.
Higher interest rates increase government interest payments and deficits. They also can reduce tax collections. But higher inflation, even if temporary, can also reduce the real value of outstanding federal debt even as it raises measured interest costs in the budget.
That said, the main issue for both people and the budget is how higher interest rates affect economic growth. Throughout much of the 21st century, the world’s developed nations relied on cheap money to keep their economies afloat. Rising interest rates may represent the end of that cheap money era. In the immediate future, a downturn may follow from this transition. Yet higher rates also hopefully promise stronger long-term growth through a more efficient allocation of resources by both government and private investors.
To understand these crosscurrents, first remember the difference between real (inflation-adjusted) and nominal interest rates. When inflation spikes unexpectedly, the real value of outstanding debt falls while the nominal costs of new borrowing rises. That benefits borrowers with outstanding debt, such as the federal government or households with mortgages. But lenders, including holders of government debt that carries a fixed interest rate, lose.
Look closely at the Office of Management and Budget’s recent budgetary statements. They show a very high level of deficit, at $1.376 billion in fiscal 2022. But they also show a decline in the ratio of federal debt to gross domestic product from 98.4 percent in fiscal 2021 to 97.0 percent in fiscal 2022. That decline is largely due to the spike in inflation during that period. At the end of World War II, the last time government debt as a share of the economy attained current levels, inflation operated as a fairly big tax on purchasers of wartime bonds.
When interest rates go up, government revenues also tend to go down. The amount of interest payments equals the amount of interest receipts on a gross basis. But the design of the tax system produces an uneven result for net revenue. Most interest receipts are garnered by those with zero or low tax rates, including nonprofits, foreigners, holders of retirement accounts, and the bank accounts of modest-income households. Most interest payments, however, are deducted from income taxes, often by those with higher tax rates, such as corporations and many individuals with large mortgages.
Inflation further encourages this type of portfolio shift, called tax arbitrage. The inflationary component of interest is deducted as if it is a real cost, when it is not, just as it leads to an overstatement of the income of lenders. The inflation subsidy or penalty per dollar of debt or interest-bearing asset is equal to the marginal tax rate times the rate of inflation. With higher inflation, debt becomes particularly advantageous for high-rate taxpayers who can borrow more to hold on to their assets.
Then, there is the impact of interest rates on the real economy. The Federal Reserve’s key policy rate was set at zero as recently as February 2022. Taking into account inflation, interest rates often have been negative for much of this century. Add in tax deductions and the true price of borrowing was even more negative for many taxable borrowers. Add yet further lax bankruptcy laws and the willingness of the Federal Reserve to protect asset values, and it is no wonder that the valuations of stocks, bonds, and real estate have grown much faster than national income.
Some may think that the resulting world-wide wealth bubble made them richer, while the low interest rates allowed the government to spend more on them without raising their taxes. And they may feel threatened by the ending of that era. But think again beyond any transition costs to what may happen if interest rates rise more permanently and the era of cheap money ends.
For one, Congress and the president will no longer be able to depend upon ever-lower interest rates to hide the long-term costs of their policies. Annual federal government interest payments as a share of GDP have not grown from 1980 to today, despite the four-fold increase in federal debt held by the public from 26% of GDP to close to 100%. That trend not only ends but reverses with higher interest rates. Budgetary interest costs will start rising at a faster rate than debt.
For another, when the cost of borrowing becomes positive, private investment turns more toward assets that on average are more productive and produce positive real returns for the economy. When the expected borrowing cost was negative, an asset only needed to produce a less negative return to produce a positive return for the investor.
What can rising interest rates mean for fiscal policy? A day of reckoning, after a very long period when ever-lower interest rates hid the long-term costs of the government’s unsustainable policies.