Due to the huge public debt, the US federal government is currently spending about $1 trillion a year to pay interest…
Illustration photo – Photo: Bloomberg.
At its monetary policy meeting in mid-September, the US Federal Reserve (Fed) cut interest rates – a move that President Donald Trump has long wanted the Fed to make to help Washington reduce its interest burden.
However, analysts say the Fed’s rate cut does not really help the US government reduce the amount of interest it has to pay. The Fed’s 0.25 percentage point reduction in the federal funds rate could reduce the cost of borrowing for the federal government when issuing short-term treasury bills (T-bills). These are short-term loans, only 4 weeks, with interest rates that basically move in sync with the Fed’s interest rate. Therefore, when the Fed lowers the policy rate, the interest rates on these bills also quickly decrease.
INTEREST BURDEN
But about 80% of the US federal debt is in notes and bonds, which have maturities ranging from 2 to 30 years. The interest rates on these bonds are fixed at the date of issuance. Even if long-term interest rates immediately reflect the Fed’s rate cut, it will take years for new debt with lower interest rates to completely replace maturing notes and bonds.
“It’s not going to make a dramatic difference to the annual budget deficit, which is approaching $2 trillion. This is just a rate cut on a very small percentage of the total federal debt,” Jessica Ridle, a senior fellow at the Manhattan Institute in New York, told the Wall Street Journal.
Furthermore, long-term interest rates in the US do not always move in tandem with short-term rates. When considering lending money to the US government for 10-30 years, bond investors also consider factors such as inflation risk, threats to the independence of the Fed, and fiscal policy. These factors can mean steeper yield curves and higher term premiums – that is, longer-term bonds have to pay higher interest rates, or the US government has to pay higher interest rates to borrow longer-term loans.
Concerns about the US fiscal outlook and policy uncertainty, which have fueled a wave of “sell America” trading this year, will have a bigger impact on the bond market than cuts in short-term interest rates, according to Jared Bernstein, chairman of the White House Council of Economic Advisers under President Joe Biden. “Investors are likely to still demand a term premium for lending to the US government,” Bernstein told the Wall Street Journal.
Interest payments are playing an increasingly large role in the federal budget, as about $1 of every $7 the U.S. government spends today is in interest payments. On average, over the past 50 years, interest payments on the national debt have been equivalent to about half of U.S. military spending. Today, interest payments on the national debt exceed U.S. military spending.
The US government has been in debt due to tax cuts, increased spending on welfare programs, and emergency responses to the Covid-19 pandemic and the 2008-2009 financial crisis. Excluding debt held by federal agencies, US public debt held by investors is approaching 100% of gross domestic product (GDP) and not far from the post-World War II record of 106%.
The massive debt pile has made the US government much more sensitive to interest rates than it has been in the past. According to estimates by the Congressional Budget Office (CBO), every 0.1 percentage point increase in all interest rates in the country costs the US government an additional $351 billion in interest payments over a decade. That is more than the amount Washington could save by eliminating subsidies for electric cars and residential solar power in Mr. Trump’s massive tax-cut and spending bill.
OPTIONS TO REDUCE INTEREST ON PUBLIC DEBT
In pressuring the Fed to lower interest rates, President Trump has argued that lower interest rates would reduce the US government’s borrowing costs. “Because interest rates are high, we pay more interest,” Trump said in June, criticizing Fed Chairman Jerome Powell for being too slow to lower rates. But as discussed above, interest rates—on both short-term and long-term debt—would need to remain low for years to make a significant difference in interest payments.
Any savings the US government could make on interest payments are unlikely to reach the figures Mr. Trump is hoping for. He is suggesting that the US could save $900 billion in interest payments a year if the Fed cuts interest rates by 3 percentage points—12 times the rate cut the Fed announced on September 17. And that estimate is based on the assumption that the average US government borrowing rate would fall along with the Fed rate.
This year, the yield on the 10-year US Treasury bond has mainly fluctuated in the 4-4.7% range. Recently, the yield on this maturity has fallen, at times falling below 4%, as investors bet that the Fed would cut interest rates. But after the Fed cut interest rates, the yield on the 10-year US Treasury bond has risen again, at times reaching nearly 4.15%.
One option to reduce the US government’s borrowing costs is for the Treasury to change the maturity profile of its bonds, increasing the proportion of short-term bills at a time when short-term interest rates are low. But Stephen Miran, Mr. Trump’s chief economist and a recent appointee to the Fed Board of Governors, argued last year that the Biden administration has borrowed too much short-term. US Treasury Secretary Scott Bessent has made a similar argument.
This year, Treasury officials have signaled they may increase borrowing in short-term Treasury bills and that long-term interest rates are too high. Washington also hopes the growth of the stablecoin cryptocurrency market will increase demand for Treasury bills.
Another option for the US to reduce its borrowing costs is to increase issuance of long-term bonds when long-term interest rates are low, as it did during the Covid-19 pandemic, when investors viewed US Treasuries as a particularly safe asset. The average yield on medium- and long-term US Treasuries exceeded 2.5% before the pandemic, then fell to 1.7% in early 2022, according to Bank of America data. But that average yield has exceeded 3% this year and continues to rise.
“There is a way of thinking that the US government should roll over its debt at lower rates, whenever it has the opportunity. And they have done so,” said Gennadiy Goldberg, head of interest rate strategy at TD Securities.
In the long run, pressuring the Fed to lower interest rates in order to reduce the US government’s debt burden could be counterproductive, according to Robin Brooks, a senior fellow at the Brookings Institution. The Fed’s excessive focus on long-term interest rates could heighten inflation fears, thereby pushing up long-term interest rates.
“It is very important that the Fed remains independent. Over time, the confidence that is built through the independence of the Fed will be the way to bring interest rates down,” Mr. Brooks said.
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