Debt ceiling impasse: Fed rate hikes are already forcing US to spend record amounts on interest payments – and it’s going to keep getting worse

Consumers and businesses aren’t the only ones feeling the pain of higher borrowing costs because of Federal Reserve rate hikes. Uncle Sam is, too.

The U.S. government spent a record US$232 billion in interest payments on its debt in the first quarter of 2023, over 50% more than a year ago and over three times what it paid in the same period of 2003. That comes as the Fed lifted interest rates a whopping 5 percentage points beginning March 2022, including a quarter point on May 3, 2023.

As an economist, I am concerned that the effect of higher interest payments on the government’s budget is being ignored – even as the debate over raising the debt ceiling puts a spotlight on the growing national debt.

Higher interest payments mean the federal government will either have to lower spending, raise taxes or issue more debt to service its obligations. And financing interest payments by issuing more debt could be a particularly poor choice – sooner or later, the bill will come due.

Getting deeper in the red

The national debt – the amount the federal government borrows to balance the budget – increases when spending is greater than revenue and accumulates over time. As a general rule, it rises over time because of increases in spending, revenue and the deficit.

Inflation, which recently has run at the fastest pace since the 1980s, tends to increase government spending, as well as revenue and deficits. As a result, the dollar value of government debt increases in times of inflation. Debt also tends to grow as the economy gets bigger – although this is not inevitable, as policymakers could choose to balance the government’s budget.

In this way, total government debt has climbed over the years – by the end of 2022, it was 10 times larger than it was in 1990. It currently stands at $31.4 trillion dollars and represents more than 120% of the nation’s gross domestic product. GDP is the total annual amount of goods and services produced by a country and often is used to judge whether debt is high or low.

Since 1990, government debt has more than doubled relative to the size of the economy, indicating that servicing debt could be quite a bit more of an issue than it once was.

A decade of record-low borrowing costs

But how concerning are these numbers? After all, it is not as if the government debt has to be paid off every year.

Government borrowing has some similarities to a person paying for an expensive item with a credit card, with the actual amount due to be paid off over an extended period. Just as with purchases on credit, interest is applied – and can add to the overall outlay. The federal government is different from consumers, though; it need not pay off its debt for the foreseeable future.

In terms of interest payments, the U.S. has been fortunate in recent years. Historically low interest rates since the 2008 financial crisis have held down interest payments. And just as low interest rates encourage would-be homeowners, for example, to take out a larger mortgage, they have also made it much more attractive for the federal government to borrow money to pay for whatever Congress and the administration want to finance.

But then came 2022. Soaring inflation, which reached levels not seen in 40 years, meant an end to the days of near-zero interest rates.

To restrain inflation, the Fed raised rates seven times in 2022 and on three more occasions in 2023, taking the base rate from near zero to a range of 5% to 5.25% as of May 2023. On May 3, the Fed signaled it may take a pause as the economy slows and a banking crisis continues to brew.

Not all government debt, however, carries these current higher interest rates. Just as with typical U.S. mortgages, much of the government debt bears the interest rate applied when it was taken on. The difference is, unlike homeowners, the government does not pay off its debt. Instead, it rolls over old debt into new debt – and when it does so, it takes on whatever the interest rate is when the debt is rolled over. And when this happens and interest rates have risen, the cost of servicing the overall debt goes up.

There may be trouble ahead

The federal government’s interest expense has only begun to reflect the higher interest rates. The average rate the U.S. paid in the first quarter of 2023 was 2.7% – that’s the most in over a decade, and it’s almost certainly going to continue to climb throughout 2023.

As for the debate over the debt ceiling, Republicans are trying to make it about the state of the nation’s finances, but months ago they ruled out addressing the most significant pieces of the national debt: Social Security and Medicare. And their plan, as passed by the House, wouldn’t actually cut spending much since it would freeze spending at last year’s levels – still higher than before the COVID-19 pandemic.

Meanwhile, Democrats, in my view, are acting as if it’s business as usual by not negotiating. And their proposal to raise taxes to reduce the deficit is very unlikely to pass the Republican-controlled House.

It may all sound a little worrying, especially amid talk of a recession. It is as if the interest on your credit card or mortgage suddenly jumped at a time when you were facing a possible cut in wages.

But there are some reassuring economic projections as well. Inflation declined substantially in the second half of 2022 and has fallen further in 2023 to 4.9% as of April.

And there is good reason to think that interest rates of 4% – or even less – are in the U.S.‘s future for 2024 and beyond, as well as in the Federal Reserve projections. Whether there will be a “soft landing” in the economy – that is, a slowdown that avoids a recession – is not so obvious. While it is not inevitable, many indicators point to a recession in 2023.

Either way, the days of the federal government borrowing trillions of dollars at near-zero interest rates to finance extravagant spending are over for the foreseeable future.

This is an updated version of an article originally published on Jan. 30, 2023.

Gerald P. Dwyer, Professor Emeritus of Economics and BB&T Scholar, Clemson University

This article is republished from The Conversation under a Creative Commons license. Read the original article.