Tomorrow, the Federal Reserve is expected to raise interest rates by 75 basis points (0.75%) for the fourth consecutive time. All attention is on the impact on the economy and the stock market, whose Dow Jones index has just finished its best month since 1976. Few are paying attention to the effect of higher interest rates and persistent inflation on Uncle Sam.
That’s surprising. Gross interest expense on the national debt hit $88 billion in August according to the Monthly Treasury Statement. That’s a stunning annualized rate of $1.06 trillion. Interest on the national debt is exploding and heading toward what economists refer to as a “doom loop”—the vicious cycle in which the government’s borrowing to pay interest generates yet more interest and yet more borrowing.
Net interest expense (gross expense minus the interest received) hit $63 billion in August, or an annual rate of $756 billion. That’s a lot of money in the context of a $6 trillion federal budget and a $25 trillion economy.
The August numbers do not even reflect a full year’s impact of the Fed’s interest-rate hikes between March and September, much less the increases expected tomorrow and beyond. It’s highly likely that gross interest expense will rise well above $1 trillion a year and surpass Social Security as the largest item in the federal budget.
The Fed’s hawkish future guidance calls for “higher rates for longer,” even if it brings on recession. The central bank is also shrinking its holdings of about $5.8 trillion of Treasury securities, of which it was a voracious buyer during the pandemic, acquiring over $3 trillion since early 2020. This will require the Treasury Department to find alternative buyers for ongoing new issues. The weakened demand will likely push rates higher, if not destabilize the Treasury market to some degree.
Yet even if the Fed backs off, or recession intervenes, that won’t relieve pressure on Uncle Sam. Treasury debt has reached record levels, and higher federal interest expense is already baked in. That will constrain Washington’s capacity to deliver fiscal stimulus to a struggling economy during the next recession. Constrained or not, the government will doubtless attempt to do so. That means issuing more debt, since the federal budget is in perpetual deficit.
That is exactly what has happened in the past 2½ years: Uncle Sam issued $7 trillion of new debt (remember the Fed bought over $3 trillion) during the Covid pandemic, which took publicly held national debt to about $24 trillion up from $17 trillion in February 2020.
The driving force behind the growth of our national debt alternates between surging interest costs attending a strong or inflationary economy and enormous additions to principal from deficit-financed stimulus during recession. In either case, the national debt is growing inexorably. How could financial markets ignore it?
One school of thought asserts that so long as the economy is growing at a faster rate than the debt, the increase in the national debt doesn’t matter.
But that certainly isn’t happening now. The current rate of $756 billion in annual net interest expense on the $24 trillion of publicly held debt implies a required economic growth rate of more than 3% in a $25 trillion economy in order for the debt “not to matter.” Yet, the average forecast for economic growth in calendar year 2022 is 1% or less, and many economists expect negative growth—i.e., recession—in 2023.
Not only are rising interest rates driving up federal interest expense dramatically; inflation is propelling growth in government spending. Social Security benefits, which are adjusted annually based on the consumer-price index, will increase 8.7% next year to roughly $1.3 trillion from $1.2 trillion.
Healthcare costs always exceed the rate of inflation. That guarantees double-digit growth next year in Medicare from about $755 billion in fiscal 2022, and in the other government healthcare programs categorized as “health” in the Monthly Treasury Statement, which amounted to $914 billion in fiscal 2022. Assuming only 10% healthcare inflation, these two categories combined will grow by $167 billion.
Naturally, if we do slip—or plummet—into a serious recession, federal income-tax revenue will erode. Even before recession, the past ten months of declining stock and bond prices virtually assure an almost complete collapse in capital-gains-tax revenue when tax returns are filed next April. Loss of that category alone—which averages about 12% of federal individual income-tax revenue—will necessitate hundreds of billions in borrowing to replace lost revenue.
Inflation and interest rates are inflicting painful damage today. Yet, seemingly without notice, the national debt is working like a cancer sapping the nation’s long-term economic vitality. Whether we reach the “doom loop,” or just become mired in stagflation, our unchecked government spending and mounting national debt will drain all growth potential from the national economy sooner rather than later.
The original version of this column appeared in The Wall Street Journal on September 30, 2022.