The Federal Reserve’s war on inflation isn’t just painful for homebuyers and people in credit card debt. Uncle Sam is also being squeezed by higher borrowing costs.
The cost of financing the growing mountain of US debt is rising rapidly as the Fed scrambles to put out the fire of inflation by raising interest rates and shrinking its balance sheet by nearly $9 trillion.
In fiscal year 2022 alone, the federal government paid out $475 billion in net interest payments, up from $352 billion the previous year, according to the US Treasury Department. For context, that’s more than the government spent on veterans’ benefits and transportation — combined. And that’s almost as much as the $677 billion spent on education.
By 2025 or 2026, the United States could hit a grim milestone: Federal interest payments could exceed the nation’s entire defense budget, according to Moody’s Analytics. For context, defense spending was $767 billion in fiscal year 2022.
While there’s little reason to doubt Washington’s ability to make interest payments, the rising cost of financing the $31 trillion U.S. debt leaves less room for Congress to spend on more. other priorities, including everything from infrastructure and the climate crisis to the military.
“It doesn’t matter who wins the midterms or in 2024, there are some really tough decisions to make. It’s really going to handcuff them,” said Dan White, economist at Moody’s Analytics.
For many years, Washington was able to borrow almost for free. The Fed kept interest rates very low to stimulate growth (and encourage inflation) and investors around the world demanded to buy US debt. This situation has made it easy and affordable for Congress and the Trump and Biden administrations to borrow aggressively.
But the situation changed from the spring of 2021 when inflation started to soar in the United States and many other major economies. The Fed was eventually forced to switch from emergency stimulus mode to inflation-fighting mode, a shift that even Fed officials admit came too late, in hindsight.
With inflation proving very stubborn, the Fed has already raised interest rates by three percentage points so far this year. Another giant-sized interest rate hike is widely expected on Wednesday when the Fed wraps up its final policy meeting, and another half-percentage-point hike in December. That would take rates to 4.5%, from near zero at the start of this year.
All of this will make it all the more expensive to finance US debt in the future.
“Low rates, a consequence of low inflation, are a catalyst. But high inflation is the kryptonite of easy money and overspending,” said Peter Boockvar, chief investment officer at Bleakley Financial Group.
Boockvar notes that during the third quarter, federal gross interest payments reached $737 billion on an annualized basis, according to last week’s GDP report. That’s up from $516 billion two years ago and rivals the nearly $800 billion expected to be spent on defense in fiscal year 2023.
But White of Moody’s notes that gross interest payments include interest the government pays itself, and net interest is the most relevant category to watch here.
The Congressional Budget Office recently estimated over the summer that net interest payments will exceed defense spending in 2029.
“It made everyone a little nervous,” White said.
Persistent inflation and rapidly rising rates have forced forecasters to continue to raise their forecasts for the cost of financing US debt. The CBO said that between July 2021 and May 2022, it increased its projection of interest rate spending through 2031 by $2.5 trillion.
Beyond raising interest rates, the Fed is aggressively shrinking the size of its massive balance sheet, which swelled to nearly $9 trillion as the central bank bought up Treasuries and bonds. other assets. Now the Fed is allowing the balance sheet to shrink by tens of billions of Treasuries each month.
“You lose a buyer,” Boockvar said.
White said the trillions of dollars in debt added under the Trump and Biden administrations have made the fiscal situation much worse.
“It’s fast-forwarded us almost an entire generation,” the Moody’s economist said.
At best, the United States is emerging from the debt mess, with the economy growing faster than interest payments.
But White fears that may not be the case, especially with a potential recession around the corner due to the Fed’s war on inflation.
A recession would likely exacerbate fiscal problems by decreasing the amount of tax revenue the government collects from businesses and individuals while simultaneously increasing public spending on unemployment, food stamps and other social protection programs.
“A recession could make things worse,” White said.
The market turmoil in the UK – and the sudden collapse of the Truss government – could prove to be a cautionary tale. Bond yields soared in the UK after former prime minister Liz Truss unveiled a budget proposal that confused investors.
“The UK bond market has experienced a crisis. With rising interest rates, the sovereign bond bubble is unwinding,” Boockvar said.
Of course, the United States is still the largest economy in the world and remains a top destination for foreign investment. And the US dollar is the world’s reserve currency.
All of these factors should help ease the burden of high debt.
“We will always be able to pay our debt because we have a printing press,” Boockvar said. “The question is what the interest rate will be on that debt.”
The answer to this question has global ramifications as US bonds are widely regarded as the safest assets on the planet. They help fix the cost of capital on everything from stocks and mortgages to emerging market debt.
“For decades, budget deficits didn’t matter and US debt didn’t matter,” Boockvar said. “Maybe all of a sudden they will.”
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