(Bloomberg) — Interest costs on U.S. debt rose to the highest since the 1990s in the fiscal year that just ended, raising the risk that budget concerns will limit policy options for the next administration in Washington.
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The Treasury Department spent $882 billion on net interest payments in the fiscal year through September — an average of about $2.4 billion a day, according to data the department released Friday. Costs were the equivalent of 3.06% as a percentage of gross domestic product, the highest since 1996.
Historically high budget deficits, which have caused total outstanding debt to soar in recent years, are a major reason for the increase. These deficits reflect a steady increase in Social Security and Medicare spending, as well as the extraordinary spending unleashed by the US in the fight against Covid and the restrictions on revenues resulting from the sweeping tax cuts in 2017. Another big driver: the inflation-induced increase in interest rates.
“The higher the interest costs are, the more politically relevant these issues are,” said Wendy Edelberg, director of the Brookings Institution’s Hamilton Project. It increases the likelihood that politicians will recognize that “financing our spending priorities through borrowing is not cost-free,” she said.
While neither former President Donald Trump nor Vice President Kamala Harris have made deficit reduction a central part of their campaign, the debt issue nevertheless looms large for the next administration. With Congress heading toward narrow partisan division, it could take only a handful, or potentially lone, budget-conscious lawmakers to thwart the tax and spending plans.
That scenario was already on display in the outgoing Biden administration, when then-Democrat Joe Manchin forced a reduction in spending that the White House chose as the price for passing signature legislative packages in 2021 and 2022.
Even if Republicans take control of both chambers, and Trump takes over the White House, the likely narrowness of the majority could give the Republican Party’s fiscal hawks the power to demand changes to sweeping tax cuts.
“It would be remarkable if next year’s tax debate emerged a whole group of policymakers who looked at our debt trajectory and decided to make it worse,” said Edelberg, a former chief economist at the Congressional Budget Office.
The net interest bill exceeded Defense Department spending on military programs for the first time, according to data from the Treasury Department and the Office of Management and Budget. It also amounted to about 18% of federal revenues — nearly double the ratio from two years ago.
The Federal Reserve’s shift toward rate cuts provides some relief for the Treasury Department. The weighted average interest rate on outstanding US debt stood at 3.32% at the end of September, marking the first monthly decline in almost three years.
Yet the scale of interest costs is now so great that they themselves contribute to the public’s total debt burden, which stands at $27.7 trillion – almost 100% of GDP. Debt servicing was among the fastest growing parts of the budget last year. Spending on interest also risks undermining economic growth by crowding out private investment.
The nonpartisan CBO estimates that every additional dollar of deficit-financed spending reduces private investment by 33 cents.
“From several perspectives, the fact that interest costs are increasing debt and causing other economic impacts is a problem for our economy,” said Shai Akabas, executive director of the Bipartisan Policy Center’s Economic Policy Program.
Treasury Secretary Janet Yellen has downplayed the concerns, saying the most important measure in assessing the sustainability of the U.S. budget is inflation-adjusted interest payments compared to GDP. That ratio has increased over the past year, but the White House expects it to stabilize at about 1.3% over the next decade. Yellen has said it is important to stay below 2%, a level seen by some as an important threshold for sustainability.
However, the White House projections assume the implementation of revenue-boosting measures proposed by the outgoing Biden administration. Harris has also called for raising taxes on the richest Americans and on corporations.
Trump says the key to addressing the budget outlook is even more tax cuts, which he says will boost economic growth and offset the hit to corporate bottom lines.
Most economists see debt levels continuing to rise under both candidates. The Committee for a Responsible Federal Budget estimates that Harris’ economic plan would increase the debt by $3.5 trillion over ten years, while Trump’s would increase the debt by $7.5 trillion.
In addition to the election outcome, the size of the Fed’s interest rate cuts will also impact the budget outlook. While rate hikes were quickly reflected in the Treasury Department’s interest bill after policymakers kicked them off in March 2022, rate cuts may take longer to bring down the government’s borrowing costs.
That’s partly because some of the U.S. debt maturing in the coming years has particularly low interest rates, which preceded the Fed’s tightening cycle. Many securities will be replaced by government bonds, which will be more expensive to manage. And that may well remain the case in the coming years – especially if the Fed stops interest rate cuts at a higher level than before the corona crisis. The Fed’s short-term interest rate averaged less than 0.75% over the ten-year period through 2019; Policymakers predicted in September that long-term interest rates would fall to around 2.9%.
In the meantime, costs associated with Social Security and Medicare will continue to rise as the U.S. population ages, contributing to excessive budget deficits for decades to come unless reforms are implemented. That pressure, and politicians’ aversion to changing popular programs, has put pressure on the remaining areas of federal spending, known as discretionary spending.
In the 1960s, discretionary spending made up about 70% of the federal total, but now the ratio is just 30%, according to analysis by Torsten Slok, chief economist at Apollo Global Management.
For now, investors are showing little concern about US fiscal woes as the Fed’s easing cycle and concerns about a weakening labor market continue to support demand for government bonds. But if and when they do, it could be decisive for Washington, said Gary Schlossberg, global strategist at the Wells Fargo Investment Institute.
“The landscape has changed,” Schlossberg said. “We used to have more of a free ride – with low fares. You could let the debts rise and that was not really reflected in the interest costs. That is clearly not there now.”
–With help from Ben Holland and Liz Capo McCormick.
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