How Interest Rates Could Affect Deficits and Debt

Interest rates have an enormous effect on how much we pay each year on servicing our debt. In the Budget and Economic Outlook from January, CBO estimated that 1 percent higher interest rates each year could increase deficits by $1.3 trillion over ten years. CBO also estimated a few other "rules of thumb" to show how changes in inflation and economic growth have significant impacts on budget forecasts. The projections show that lower economic growth of just 0.1 percentage point each year could increase deficits by $310 billion over ten years, while 1 percentage point higher inflation each year could add almost $900 billion to deficits.

With that in mind, CBO recently released an analysis in response to a request from Rep. Paul Ryan (R-WI) looking more in depth at what different interest rate scenarios would do to deficits and debt over a ten-year window.

  10-Year Average for 3-Month Bills 10-Year Average for 10-Year Notes
Cumulative Deficits Above Baseline (Billions)*
CBO Baseline 3.3% 4.8% $0
1991-2000 3.8% 5.8% $1,054
1981-1990 6.4% 8.8% $5,079
Blue Chip 4.0% 5.7% $1,178

*CBO projects baseline deficits to total $6,971 billion over the 2012-2021 period.

CBO modeled four different scenarios: their current law projections, one based on the average rate from 1991-2000 (scenario 1), one based on the average rate from 1981-1990 (scenario 2), and one based on the ten highest interest rate projections in the Blue Chip economic forecasts of October 2010 and February 2010 (scenario 3).

 
As can be seen in the graphs, higher interest rates--as in the 1981-1990 experience--can significantly increase deficits and debt. Scenario 1 adds about $1.1 trillion more to cumulative baseline deficits, scenario 2 adds about $5.4 trillion, and scenario 3 adds about $1.2 trillion.
 

 

How can we help keep interest rates low and make sure investors remain confident in the United States' fiscal path? Easy, a comprehensive fiscal plan that tackles our long-term budget challenges in order to reassure markets that we're serious about controlling future deficits.

 

 The CBO's analysis appears

 The CBO's analysis appears to have overlooked one important facet of inflation: that it reduces the real value of outstanding debt. 1% more inflation will drive nominal interest rates up 1%, but that will be offset by a 1% decline in the real outstanding debt.

 

Indeed, based on the CBO's Table B-1, 150% of the deficit increase from inflation is due to higher nominal costs. Subtracting out the equivalent lower real debt gives a real deficit reduction of $444 B.

 

Which is not to say that inflation is a good debt reduction strategy. But it isn't real debt increasing, either.

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