The U.S. government’s persistent budget deficit and growing debt were at the bottom of Wall Street’s list of concerns when interest rates were at their lowest point for years. But borrowing costs have risen so much that many investors and economists fear that the United States’ large debt pile may prove less sustainable.
Federal Reserve officials have raised interest rates to about 5.3 percent since the start of 2022 to curb inflation. Officials predicted at their meeting last month that interest rates could remain high in the coming years, shattering the expectations of investors who had been betting that rates would fall significantly as early as next year.
The realization that the Fed could keep borrowing costs high for a long time, along with a mix of other factors, has led to a rise in long-term interest rates in financial markets. The interest rate on the 10-year Treasury note has risen since July and this week reached its highest level in nearly two decades. That’s important because the 10-year Treasury bond is something of a backbone of the market: It helps drive up many other borrowing costs, from mortgages to corporate debt.
The exact cause of the recent rise in Treasury interest rates is difficult to determine. Many economists say a combination of factors is likely helping drive the recovery — including strong growth, fewer foreign buyers of American debt and concerns about debt sustainability in and of itself.
It is clear that if interest rates remain high, the federal government will have to pay investors more interest to finance their borrowing. America’s gross national debt is just over $33 trillion, more than the entire annual output of the American economy. Debt is expected to continue to grow both in dollar terms and relative to the economy.
While the rising cost of holding such high levels of debt is fueling debate among economists and investors about the appropriate level of annual national debt, there is no consensus in Washington on deficit reduction in the form of higher taxes or big spending cuts.
Still, the renewed concern is a significant reversal after years in which mainstream economists increasingly believed that the United States may have been too timid about its debt: years of low interest rates had convinced many that the government could borrow cheap money to pay for it to provide relief in times of economic difficulties and to invest in the future.
“How big the problem of deficits is depends on — and it depends crucially on interest rates,” said Jason Furman, a Harvard economist and former economic official under the Obama administration. “That has changed a lot,” so “your view of the deficit should change too.”
Mr. Furman had previously estimated that rising interest costs on federal debt would remain sustainable for some time, taking inflation and economic growth into account. But now that interest rates have risen so sharply, the calculus has shifted, he said.
Since 2000, the United States has run an annual budget deficit, meaning it spends more than it receives in taxes and other revenue. The gap was filled by borrowing money.
Tax cuts, spending increases and emergency economic aid approved by both Democratic and Republican presidents have helped fuel rising deficits in recent years. This also applies to the aging of the American population, which has driven up the cost of Social Security and Medicare without corresponding increases in federal tax rates. The deficit as a share of the economy rose this year under President Biden, even as the economy grew, just as it did in the pre-pandemic years under President Donald J. Trump.
Now borrowing costs are likely to widen the gap.
Higher interest rates, along with surprisingly weak tax revenues, are a key reason Congress’s budget deficit will double over the last year. If measured correctly, the deficit grew from $1 trillion in fiscal year 2022 to an estimated $2 trillion in fiscal year 2023, which ended last month.
If borrowing costs continue to rise — or simply stay where they are for an extended period of time — the government will pile on debt much faster than officials expected just a few months ago. A budget update released by Biden administration economists in July projected that average annual interest rates on 10-year Treasury bonds would not exceed 3.7 percent at any point over the next decade. These interest rates are currently around 4.7 percent.
The recent rise in longer-term bond yields is due to a number of factors.
While the Federal Reserve has been raising short-term interest rates for about 18 months, longer-term bond rates have remained relatively stable in the first half of this year. But investors have slowly come around to the possibility that the Fed will keep interest rates higher for longer, in part because growth has remained solid despite increased borrowing costs.
At the same time, there were fewer buyers for government bonds. The Fed has been shrinking its bond balance sheet as it reverses its pandemic-era stimulus policies, meaning it is no longer buying Treasuries – taking away a source of demand. And important foreign governments have also withdrawn from bond purchases.
“We have narrowed down to a smaller universe of buyers,” said Krishna Guha, head of global policy and central bank strategy at Evercore ISI.
Some analysts have suggested that the rise in bond yields could also be related to concerns about debt sustainability. To pay higher interest costs, the government may have to issue even more debt, exacerbating the problem – and drawing attention to America’s huge debt pile, said Ajay Rajadhyaksha, global head of research at Barclays.
“The problem is not just that number,” he said, pointing to the increasing deficit. “The problem is this economy is as good as it gets.”
That, as several economists have said, is the crux of the problem: America is borrowing heavily even at a time when unemployment is very low and growth is strong, so the economy doesn’t need much government help.
“Right now we have an incredible amount of issuance while the Fed announces higher interest rates for an extended period of time,” said Robert Tipp, chief investment strategist at PGIM Fixed Income, noting that typically in turbulent times, the Central bank policy prevails, higher emissions occur is more accommodating. “This is like a wartime budget deficit, but without any help from the central bank. That’s why it’s so different.”
White House officials say it is too early to say whether rising bond yields should prompt Mr. Biden to add new deficit reduction proposals to the $2.5 trillion plans he included in this year’s budget. These proposals consist largely of tax increases on corporations and high earners.
“We could be having a different discussion about this in a month,” said Jared Bernstein, chairman of the White House Council of Economic Advisers. “And when you write budgets, don’t lightly go back and change your path.”
The Treasury has sold nearly $16 trillion in debt this year through September, up about 25 percent from the same period last year, according to the Securities Industry and Financial Markets Association. Much of this issuance replaced existing maturing debt, leaving net debt issuance of about $1.7 trillion, more than at any other time in the last decade except for the pandemic-related bond glut in 2020. The The Ministry of Finance’s own advisory committee predicts that the volume of government debt sales will increase by a further 23 percent in 2024.
Maya MacGuineas, chairwoman of the bipartisan Committee for a Responsible Federal Budget and a longtime advocate of deficit reduction, said it’s hard to say what caused the recent rise in interest rates. Still, she said, the move serves as a “reminder.”
“From a fiscal policy perspective, the story is simple: If you borrow too much, you become more and more vulnerable to higher interest rates,” she said.
Santul Nerkar contributed reporting.