Federal Debt Under Alternative Paths for Interest Rates

This letter responds to Congressman Jason Smith's request for the Congressional Budget Office’s estimate of the effects of higher interest rates on federal debt over the long term.

CBO’s most recent 30-year projections, which are called its extended baseline projections, were published in March 2021. As part of that analysis, CBO projected economic and budgetary outcomes under scenarios in which federal borrowing rates were either higher or lower than the rates underlying the agency’s extended baseline.

• In the first scenario, federal borrowing rates are boosted above the baseline rate by a differential that starts at 5 basis points in 2021 and increases by 5 basis points each year (before macroeconomic effects, which are described below, are accounted for). In that scenario, federal debt held by the public equals 260 percent of gross domestic product (GDP) in 2051, rather than the 202 percent of GDP in the extended baseline projections.
• In the second scenario, federal borrowing rates are pushed below the baseline rate by those same amounts each year, and federal debt held by the public equals 160 percent of GDP in 2051.

In the first scenario, CBO’s analysis starts with the boost to borrowing rates, which increases the government’s interest costs. Deficits therefore grow. Those larger deficits decrease private investment, reducing the amount of capital per worker. The reduction in the amount of capital per worker means that the value of any additional capital is now higher than it would otherwise have been. Put differently, the return on capital grows, further pushing up interest rates. Those interest rates include the federal borrowing rate, which thus rises more than the initial boost.

The average federal borrowing rate reaches 6.6 percent in 2051 in the higher interest rate scenario, rather than the 4.6 percent rate for that year in the extended baseline. The rate of 6.6 percent reflects both the scenario’s initial boost of the borrowing rate and the resulting effects of larger deficits, less investment, and less capital. About a quarter of that 2.0 percentage-point difference results from those macroeconomic effects rather than representing the boost to borrowing rates that the analysis began with.

In the second scenario, smaller interest payments result in smaller deficits. Those smaller deficits increase private investment, making the amount of capital per worker grow and the return on capital fall. The federal borrowing rate falls to 2.7 percent in 2051.

The budgetary effects of higher or lower interest rates are highly uncertain because those effects depend on the amount of debt that the interest rates are applied to and the macroeconomic effects of the higher rates. Also, this analysis does not explicitly account for the budgetary effects that might stem from the sources of the changes in interest rates. Moreover, interest rates themselves could differ from the values specified in the scenarios examined here.