An Interesting Analysis of Interest Rates

The Congressional Budget Office has been busy on its blog lately, posting both snapshots of federal programs and also publishing responses to questions they have received from Members of Congress at hearings. Their latest post from director Doug Elmendorf is the latter variety, showing the sensitivity of budget projections to changes in interest rates.

Of course, interest rates are a big factor in a government's interest burden. As an example, the low interest rates the federal government currently faces allow them to pay the same amount in nominal dollars as they did in 2000, despite debt held by the public being more than three times higher.

To see the effect of interest rates on the federal budget, the CBO models three alternate scenarios to their baseline economic projections:

• Nominal interest rates rise to their average for 1991-2000.
• Nominal interest rates rise to their average for 1981-1990.
• Nominal interest rates follow a path consistent with the average of the highest ten economic forecasts in the October 2012 and February 2013 Blue Chip publications.

Using those parameters gets the three-month and ten-year interest rates for Treasury securities seen below. Scenario 2 has by far the highest interest rates, in part due to the higher inflation that prevailed particularly at the beginning of the 1980s.

^{Source: CBO}

CBO also shows how these different scenarios would affect deficits. Scenario 1 would increase ten-year deficits by $1.4 trillion, Scenario 2 would increase them by $6.3 trillion, and Scenario 3 would increase them by $1.1 trillion. These numbers come with a caveat that they do not account for other economic changes which may drive or be the result of the higher interest rates. Higher inflation or better economic performance than CBO expects could be a driver of higher interest rates. Similarly, high interest rates themselves could harm economic growth or otherwise cause the Federal Reserve to tighten monetary policy, affecting other economic indicators. All of these factors would affect the budget through channels other than their effect interest payments, but CBO holds their other economic projections constant.

Also, the fact that CBO uses nominal interest rates means that Scenarios 1 and 2 may be a less telling indicator of future interest rates, since inflation rates going forward may differ from those in the 1980s and 1990s -- CBO's projections have them lower -- or other factors could mean that even real interest rates are lower than in those two decades, which is the case in CBO's baseline projection. Scenario 3 would likely be more telling in terms of how a higher interest rate alternate scenario could look in the coming years, again with the caveat that the higher rates could be the result of other factors which themselves would affect budget projections.

Still, the numbers give an idea of the effect of interest rates on debt. We used CBO's deficit numbers to project what debt held by the public as a percent of GDP would be in each scenario. 

^{Source: CBO}

The low interest rates we are currently experiencing are unlikely to last for a long time, but the path they take to rise and what "normal" they reach has profound implications for the budget outlook. As we've said before, perhaps the best takeaway is to err on the side of caution, agreeing upon a plan with enough deficit reduction to put it on a downward path even if CBO's projections end up being overly optimistic.