Federal debt held by the public will reach about $12.8 trillion by the end of this fiscal year, an amount that equals 74 percent of the nation’s total output (gross domestic product, or GDP) this year. If current laws generally remained unchanged—the assumption that underlies CBO’s baseline projections—CBO projects that such debt would climb to $20.6 trillion, or 77 percent of GDP, in 2024.
Interest payments on that debt represent a large and rapidly growing expense of the federal government. CBO’s baseline shows net interest payments more than tripling under current law, climbing from $231 billion in 2014, or 1.3 percent of GDP, to $799 billion in 2024, or 3.0 percent of GDP—the highest ratio since 1996. The rising debt accounts for some of that increase, but much of it stems from CBO’s expectation that—largely owing to the improving economy—the average interest rate paid on that debt will more than double over the next 10 years, from 1.8 percent in 2014 to 3.9 percent in 2024. (Although interest rates are projected to rise sharply, CBO’s current projections of those rates are lower than its projections earlier in the year, reflecting the agency’s reassessment of the factors influencing real interest rates.)
This blog post highlights some of the discussion about federal interest costs in An Update to the Budget and Economic Outlook: 2014 to 2024, which CBO released last week.
Projected Federal Debt
Federal debt held by the public consists mostly of securities that the Treasury issues to raise cash to fund the federal government’s activities and to pay off its maturing liabilities. It does not include Treasury securities held by federal trust funds and other government accounts; interest payments on those securities are intragovernmental transactions, which appear in the budget as interest costs to the Treasury and receipts to the trust funds and other accounts, having no net effect on the federal deficit. (For more discussion, see CBO’s report Federal Debt and Interest Costs.)
The net amount that the Treasury borrows by selling securities to the public (the amounts that are sold minus the amounts that have matured) is influenced primarily by the annual budget deficit. In addition, the Treasury borrows to provide financing for student loans and other credit programs; the budget reflects the projected subsidy costs for those programs, rather than the cash disbursements. In its baseline projections, CBO projects that—if current laws generally remain unchanged—federal deficits would total $7.2 trillion between 2015 and 2024 and additional borrowing, often called “other means of financing,” would total roughly $560 billion during that period. After accounting for all of the government’s borrowing needs, CBO projects that debt held by the public would rise by $7.8 trillion between the end of 2014 and the end of 2024, an increase of more than 60 percent. The debt measured as a percentage of GDP would also rise, but not as dramatically because the economy will also grow over that period.
|CBO's Current and Previous Projections Related to Federal Interest Payments|
|Net Interest (Billions of dollars)|
|Debt Held by the Public (Billions of dollars)|
|Interest Rate on 3-Month Treasury Bills (Percent)|
|Interest Rate on 10-Year Treasury Notes (Percent)|
|Average Interest Rate on Debt Held by the Public (Percent)|
|Federal Funds Rate (Percent)|
|Notes: CBO's previous budget projections were released in April 2014. The agency's previous economic forecast was published in February 2014.
The federal funds rate is the interest rate on overnight lending among banks, which is adjusted by the Federal Reserve as one of its principal tools for conducting monetary policy.
Values for the interest rates on three-month Treasury bills and ten-year Treasury notes, as well as for the federal funds rate, are on a calendar year basis. Values for net interest, debt held by the public, and the average interest rate on debt held by the public are on a fiscal year basis.
Projected Interest Rates
Between calendar years 2014 and 2019, CBO expects, the interest rate on 3-month Treasury bills will rise from 0.1 percent to 3.5 percent and the rate on 10-year Treasury notes will rise from 2.8 percent to 4.7 percent; both are projected to remain at about those levels through 2024 (see the figures below). After 2014, the projected 3-month Treasury rate is a bit below the projected federal funds rate—the interest rate on overnight lending among banks, which is adjusted by the central bank as one of its principal tools for conducting monetary policy—which rises to 3.8 percent by 2019 and remains at that level through 2024.
CBO expects that monetary policy will continue to support an improvement in economic growth during the next few years because some slack will persist in the labor market and inflation will stay below the Federal Reserve’s goal. (For highlights of CBO’s analysis of the labor market, see yesterday’s blog post, Slack in the Labor Market in 2014.) The Federal Reserve has stated that it expects to keep its target for the federal funds rate near zero for a considerable time, especially if conditions in the labor market signal that the statutory objective of maximum employment has not been reached and if inflation and expectations for inflation remain low. Accordingly, CBO projects that the federal funds rate will remain near zero until the second half of 2015 and then rise considerably. The 3-month Treasury bill rate is projected to increase in a similar fashion. Those projections are broadly consistent with expectations for short-term interest rates as indicated by prices in financial markets.
The 10-year Treasury rate began rising from very low levels in 2012 and is currently close to 2.4 percent, still low by historical standards. That rate will be pushed up over time by market participants’ expectations of an improving economy, the rise in short-term interest rates, and an end to the Federal Reserve’s purchases of long-term Treasury securities and mortgage-backed securities, CBO anticipates.
The projected increase in market interest rates would affect the government’s borrowing costs as the Treasury replaced maturing debt and issued additional debt to finance budget deficits and for other means of financing. CBO projects that, under current law, the average interest rate on debt held by the public—calculated as net interest divided by debt held by the public—will rise from 1.8 percent this year to 3.9 percent a decade from now.
Factors Influencing Real Interest Rates
In considering projections of interest rates, it is useful to consider them in two components: the component that is attributable to inflation, and the real interest rate, which excludes the effects of inflation. Adjusting for inflation as measured by the CPI-U, the projected real interest rate on 10-year Treasury notes is 2.3 percent between 2018 and 2024. That rate is well above its current level but roughly ¾ percentage point below its average between 1990 and 2007, a period that CBO uses for comparison because it featured fairly stable expectations for inflation and no significant financial crises or severe economic downturns. (Looking further back, the real interest rate on 10-year Treasury notes averaged 3.2 percent between 1970 and 2007 and 2.9 percent between 1953 and 2007. ) In CBO’s assessment, the factors that will tend to reduce real interest rates on Treasury securities over the projection period relative to their 1990–2007 averages will have a larger total effect than the factors that will tend to increase those rates. (For a more detailed version of this material, see pages 108 to 110 of The 2014 Long-Term Budget Outlook.)
Specifically, CBO expects that four factors will reduce real interest rates on government securities relative to their earlier average:
- Slower growth in the labor force will tend to raise the amount of equipment and other capital per worker, reducing both the return on capital and the return on competing investments, such as Treasury securities.
- A higher share of total income going to high-income households will tend to increase the overall saving rate, raising the amount of savings available for investment and thus the amount of capital per worker.
- Slightly slower productivity growth will tend to reduce the return on capital and interest rates.
- The risk premium demanded by investors to hold assets that are riskier than Treasury securities will probably remain larger over the next decade than it was, on average, over the 1990–2007 period, lowering interest rates on those securities.
However, CBO expects that the following factors will tend to increase real interest rates on government securities relative to their earlier average:
- Under current law, federal debt will be much larger as a percentage of GDP than it was before 2007, so federal borrowing will tend to crowd out additional private investment in the long run and reduce the amount of capital per worker.
- Over the coming decade, smaller net inflows of capital from other countries as a percentage of GDP will restrain domestic investment and the amount of capital per worker.
- A higher share of income going to capital relative to the average over the 1990–2007 period will boost the return on capital and thus interest rates.
- A smaller number of workers in their prime saving years relative to the number of older people drawing down their savings will decrease the total amount of savings available for investment and the amount of capital per worker.
Revisions to Projected Federal Interest Payments
CBO’s current projections of interest rates are lower than the projections it made earlier this year, reflecting the agency’s reassessment of the factors influencing real interest rates (see the figures earlier in this post). That reassessment involved both reconsidering the relative importance of factors that had been included in the agency’s previous analyses, such as the growth of the labor force, and adding factors not incorporated before, such as the effect of income inequality on the saving rate, the risk premium, the share of output going to owners of capital, and the effect of an aging population on the saving rate.
Updates to CBO’s projections of interest rates have decreased projected net outlays for interest over the next decade. For the 2015–2024 period, projected net interest payments have been revised down by $469 billion because of the downward revision to interest rates. (Projected net interest payments for that period have been revised down by an additional $149 billion for other reasons; for a description of those revisions, see “Changes in CBO’s Baseline Since April 2014,” Appendix A of the recent Update.) By 2024, in CBO’s projections, federal debt held by the public is now about 2 percent less than CBO projected in April, but net interest costs are 9 percent less. Nonetheless, rising interest rates and growing federal debt are still projected to raise net interest payments significantly over time.
Wendy Edelberg is CBO’s Assistant Director for Macroeconomic Analysis.