Fiscal sustainability under higher rates

US fiscal policy will come under scrutiny if rates settle permanently higher

• Fiscal sustainability is no longer on everyone’s lips, but structurally higher yield curves will feed into growing interest payments in coming years given the maturity structure of public debt in the United States;

• In contrast to the 1970s and 1980s, when high rates combined with a relatively low initial stock of public debt, high debt levels today bring fiscal risks therefore;

• A high inflation scenario, with the 10Y US Treasury increasing to 4%, sees interest payments nearly triple in percent of GDP to absorb about one-fifth of Federal government tax receipts by the end of this decade;

• This does not mean fiscal sustainability is immediately in doubt, but it will likely become a political issue—and in any case, encouraging the Fed to target a higher inflation rate would be one simple way of managing this risk.

It’s funny how the sustainability of public sector finances has slipped under the radar in recent years. The Eurozone Crisis a decade ago led to great fears about sustainability, encouraging a premature shift to austerity. But once it became clear that such concerns are largely irrelevant for those with truly elastic currencies—alongside the accent of Modern Monetary Theory (MMT)—the matter of public debt sustainability has been, correctly, set aside.

It’s difficult to imagine such neglect will last long, however. Post-pandemic reflation is seeing central banks act to offset high and accelerating inflation; the yield curve has awoken from a decade of slumber.

Once the impact of a persistently higher yield curve feeds into refinanced debt stocks, interest payments could exceed anything experienced before.

Baked-in interest payments

Let’s start with the existing debt stock.

The outstanding stock of US Federal government debt securities reached USD30.4 trillion in March, or just short of 130% of GDP—having increased from about 108% of GDP before the pandemic (GDP was USD24 trillion in December, annualized).

Of this debt, USD23.9 trillion is debt held by the public and USD6.5 trillion as intergovernmental holdings.

We focus here on the former stock, that held by the public (including the Fed), which registers about 100% of GDP. This debt matures over the next 40 years, with the majority (USD20 trillion) maturing over the next decade and about USD4 trillion between the late-2030s and 2051.