Walking the Debt - Interest Rate Tightrope

With the American debt and deficit situation making the 24 hour news cycle over the past couple of weeks, I found this research by the Committee For A Responsible Federal Budget (CFRB) interesting, particularly as it parallels many of my postings over the past three years.

Let's open by looking at the history of interest rates on a three-month Treasury bill:

and the history of interest rates on a ten-year Treasury note:

Currently, the three-month Treasury bill is yielding a whopping 0.04 percent, up from its all-time low of 0.01 percent in late 2011.  The ten-year Treasury note is yielding 2.63 percent, up from its low of 1.43 percent in July 2012 and its 2013 low of 1.66 percent in early May.  To put these numbers into perspective, since 1990, three-month Treasury bills have yielded an average of 3.3 percent and ten-year Treasury notes have yielded an average of 5.2 percent. 

Earlier this year, the Congressional Budget Office projected that the interest rates on ten-year Treasuries would rise to 2.7 percent in 2014 (this has already been passed), 4.3 percent in 2016 and 5.2 percent from 2018 onward.  The CBO projects that interest rates on three-month Treasuries will rise to 4 percent from 2018 onward.  Here is a graphic showing actual and projected interest rates from the Office of Management and Budget (OMB), the IMF and the CBO:

All organizations are suggesting that interest rates will rise substantially over the next five years.

In today's alternate interest rate reality, it is obvious that the biggest beneficiary of Mr. Bernanke's Grand Experiment has been the federal government.  Total interest owing on the debt for fiscal 2013 is projected to be "only" $225 billion.  While this seems a huge sum (and it is), it is the same amount of interest that accrued back in 2006 when the level of the federal debt was only 40 percent of its current level!  Unfortunately, that situation is unlikely to persist.

Using the projections as noted above, the CFRB's projections suggest that the current interest rate environment will not end with a whimper. Spending on interest payments will rise to $505 billion by 2018 and $844 billion by 2023; over the coming decade, interest owing on Washington's debt is projected to grow by 400 percent at the same time as the debt itself is only projected to grow by around 60 percent.

Here is a graphic showing how interest on the debt (in green) will comprise an ever-growing portion of total spending by Washington:

By 2025, interest payments will hit nearly 4 percent of GDP and will exceed the cost of all non-defense discretionary programs including education, homeland security, the civilian workforce, food stamps, homeland security and federal retirement spending.  By 2045, interest payments will be in excess of 7 percent of GDP and will exceed all of these programs plus the entire defense budget and will be as large as spending on the entire Social Security program, the federal government's largest spending obligation.  

Here is a bar graph showing how spending on interest payments on the federal debt will compare to spending on other government programs as the decades pass:

Now, let's look at an even more frightening scenario.  You will recall that interest rates have been quite a bit higher over the past two decades than a mere 5.2 percent for a ten-year Treasury.  In fact, through most of the economically tough 1970s, ten-year Treasuries yielded between 7 and 9 percent, a great deal higher than the projections from the CBO, IMF and OMB.  The CFRB looks at other scenarios as follows:

1.) An interest rate increase of just one percentage point above projections each year for Treasuries of all maturities will increase borrowing by $1.2 trillion over the 2014 -2023 period, solely from increased interest owing on the debt.  This will wipe out all of the savings from sequestration in one fell swoop.  This would push the debt-to-GDP up by 4 percentage points by 2023, 10 percentage points by 2030 and 36 percentage points by 2050, thanks in large part to compounding.

2.) If interest rates rise to the average level of the 1990s (6.7 percent for a ten-year Treasury) or 1.5 percent higher than the CBO's projections, deficits would increase by over $1.4 trillion.  This would push the debt-to-GDP ratio up by 5 percentage points in 2023, 14 percentage points by 2030 and 56 percentage points by 2050, again, thanks to compounding.

3.) If interest rates rise to the average level of the 1980s (10.6 percent), deficits would increase by a massive $6 trillion, again, solely from increased interest owing on the debt.

On an average month, roughly $650 billion worth of debt is either issued or rolls over.  This means that higher interest rates would very quickly work their way through the system, resulting in higher interest outlays for the Treasury.

In the context of history, we are living in an alternate interest rate reality.  This alternate reality has allowed Washington to continue to borrow and spend as though there were no long-term repercussions since the political reality for the Republicans and Democrats is lived in two year, election cycle segments.  They would rather argue about mundane and relatively meaningless issues than look at the debt land mine that they are creating for future generations.  A rise in interest rates may bring them back to the reality that the rest of us live in, however, I rather doubt it.  It may be a lesson that has to be learned the hard way and interest rates may be the teacher.