Rising Interest Rates Could Add to Budget Woes
As the federal government closed its books on fiscal year 2018 at the end of September, interest rates were rising to levels not seen in a decade, signaling the possibility of further deterioration in the budget outlook for 2019 and beyond.
The past year has been very positive for the U.S. economy but a step in the wrong direction for fiscal policy. The Congressional Budget Office (CBO) reports that the deficit for fiscal year 2018 was $782 billion, or 3.8 percent of GDP, up from $666 billion, or 3.5 percent of GDP, in 2017. In 2015, the deficit was 2.4 percent of GDP. From 1968 to 2017, the federal government ran an average deficit of 3.0 percent of GDP.
The deficit would have been $862 billion in 2018 if not for the movement of some expenditures out of 2018 and into 2017 (the shifts occur when certain monthly payments get moved forward because the fiscal year ends on a weekend). After controlling for the timing shifts, federal spending increased 4.4 percent in 2018.
The gap between revenue and spending widened in 2018 mainly because federal tax receipts were essentially flat, growing by just $13 billion, or 0.4 percent. With the economy growing strongly, federal revenue should have increased by a much larger amount, and would have had it not been for the tax cuts enacted in December 2017. In particular, the new tax law reduced the tax rate for corporations and allowed an immediate deduction for equipment purchases. As a result, corporate tax receipts fell by 31 percent in 2018. Trump administration officials have argued that the tax cut will pay for itself with a growth-induced surge in tax receipts, but the evidence so far suggests otherwise.
The fastest growing line item in the budget was for net interest payments on outstanding federal debt, which was up 19 percent in 2018 compared to 2017.
The government’s interest costs may rise even more this year as interest rates are now moving up steadily. The interest rate on 10-year Treasury notes is 3.2 percent, up from 2.9 percent at the end of August and from 2.4 percent one year ago. The interest rate on 1-year Treasury bills is now 2.7 percent, up from just 0.8 percent in January 2017. The yield on 30-year Treasury bonds is now 3.4 percent, up from 2.9 percent one year ago.
A steady rise in interest rates is a sign of normalization. The federal government borrowed heavily during the deep recession that occurred from 2007 to 2009, and during the slow recovery that followed. But because interest rates were abnormally low, the government’s net interest costs didn’t increase. In 2008, the government had outstanding debt of $5.8 trillion, or 39 percent of GDP, and made net interest payments totaling 1.7 percent of GDP. By 2017, federal debt had grown to $14.7 trillion, or 77 percent of GDP, but net interest payments had fallen to 1.4 percent of GDP. After the financial crash of 2007-2008, the Fed sought to keep interest rates low for a sustained period to stimulate growth, which also allowed the federal government to borrow heavily without a large increase in costs associated with servicing the new debt.
That’s now changing. As economic growth accelerates, and the Fed tightens monetary policy, interest rates are beginning to resemble what they were before the financial crisis. If current trends continue, the federal government will be forced to pay higher interest rates on borrowed funds, and budget deficits will widen accordingly.
CBO’s current baseline assumes interest rates will continue rising in 2019 and 2020. The agency expects the rate for 3-month Treasury bills will rise from an average of 1.9 percent in 2018 to 2.8 percent in 2019 and to 3.1 percent in 2020. Similarly, CBO’s baseline assumes the interest rate for 10-year Treasury notes will rise from an average of 3.0 percent in 2018 to 3.6 percent in 2019 and to 3.9 percent in 2020.
Budget deficits in the coming year will be higher if interest rates rise more rapidly than is assumed in CBO’s forecast. CBO has developed rules of thumb that allow adjustments to deficit estimates based on revised economic assumptions. Each 0.1 percentage point increase in interest rates on federal debt adds $164 billion to the cumulative, 10-year deficit forecast. CBO’s current baseline shows the federal government running a cumulative deficit over the next decade of $12.4 trillion. If interest rates are, on average, 0.5 percent higher than CBO now assumes, then the deficit would widen by an additional $820 billion. If interest rates are a full percentage point higher, then the 10-year deficit would increase by $1.6 trillion.
Interest rates above the levels in CBO’s baseline forecast would not be unusual. CBO assumes the nominal interest rate on 10-year Treasury notes will be 3.7 percent from 2023 to 2028. With inflation expected to be 2.4 percent annually, the implied real interest rate on 10-year Treasury notes is 1.3 percent. That is well below what was the norm in the pre-financial crash era. From 1990 to 2007, the average real interest rate on 10-year Treasury notes was 3.0 percent.
For the first time in several years, the U.S. economy is expanding at a pace that is driving up wages, inflation, and interest rates. This is welcome news. But an acceleration in economic growth also means higher net interest payments for the government. It will not be as cheap in the coming years to borrow money as it has been over the past decade.
Unfortunately, political cycles usually do not line up well with business cycles. When the economy is expanding, political leaders don’t want to rock the boat. But now is exactly the right time to restrain projected deficits with reforms of government programs. The economy doesn’t need more stimulus; indeed, fiscal restraint would add to the potential growth rate over the medium and long run.
The window of opportunity won’t be open for long, though. The economy could slow in the coming year or two for any number of reasons. If that were to occur, there will be renewed calls for fiscal and monetary stimulus, and the deficit projections will quickly go from very bad to even worse.
James C. Capretta is a RealClearPolicy Contributor and a resident fellow at the American Enterprise Institute.
