Will High Government Debt Create Problems As Rates Rise?

In 2022 interest rates have shot up, and there’s likely more rate hikes to come from the Fed. This is unlikely to impact the U.S. government debt in the near term, but may present an issue over the coming years if interest rates remain elevated.

If rates were to remain at around current levels, it would ultimately cause more government expenditure to go to paying interest on the national debt. That additional interest cost could amount to double what the government spends on veterans, or half the U.S. defense budget.

Recent Trends In Debt to GDP

Since the financial crisis in 2008 U.S. government debt to gross domestic product (GDP) has approximately doubled from 63% to 121%. However, over that same period interest rates declined relatively steadily.

This meant that even though the U.S. had more debt over recent decades, the interest cost on the debt compared to GDP has been broadly flat. Lower interest rates largely offset the higher debt.

Rising Interest Costs

Now that may be changing. Interest rates have broadly returned to where they were before 2008 and government debt compared to GDP has doubled since then. This won’t cause the borrowing costs of the U.S. government to rise immediately. That’s because the weighted average duration of U.S. debt is between five and six years. This means that U.S. government debt won’t reprice to market interest rates overnight, but government interest costs could steadily rise over this decade.

For example current interest rates on U.S. government debt are around two percent on average for 2022. If that level of interest rates doubled to four percent, which is a reasonable reflection of where U.S. government debt trades in the secondary market today, then that would be a significant addition to government spending.

A doubling of expenditure on interest, would add a cost roughly equal to half the Medicare budget. That’s manageable, but not trivial.

Also the Fed plans to raise rates further, illustratively if interest rates were to hit six percent then spending on interest on the national debt could ultimately rival Social Security spending, the largest single item of government spending. The markets currently expect the Fed to stop raising rates well before six percent is hit and are unsure that we’ll even see five percent rates at the short end of the curve, but it shows that if the Fed fights inflation too aggressively it may present issues for management of the federal budget.

Historical Precedent

However, a doubling of interest cost compared to GDP would not be unprecedented. In the early 1990s interest cost was around three percent of GDP, or double current levels. Also, debt to GDP in the U.S. has declined slightly since the pandemic from a high of 135%. Currently high inflation may bring the ratio down further as inflation means GDP is growing faster than the debt, as the value of the national debt is largely fixed in nominal terms.

A Consideration For Western Economies

Still this may become an issue for markets over the coming years if interest rates remain at current relatively high levels compared to recent history. The recent U.K. experience has demonstrated the risks when markets start to lose confidence in the fiscal position of a government. This is also a relatively broad issue. Many developed economies including Canada and much of Europe have high debt to GDP today and are seeing rising interest rates in the current market.

Of course, we may be close to the top of the current interest rate cycle, meaning this issue may fade if interest rates fall as inflation recedes, but if interest rates do continue to rise in 2023, then this issue topic become more relevant to many western governments and those that invest in their national debt.