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Next week, the Federal Reserve is expected to send a clear signal that it will end its policy of holding short-term U.S. interest rates low sooner rather than later. Here’s coverage from the Wall Street Journal:
Federal Reserve officials are seriously considering an important shift in tone at their policy meeting next week: dropping an assurance that short-term interest rates will stay near zero for a “considerable time” as they look more confidently toward rate increases around the middle of next year.
Senior officials have hinted lately that they’re looking at dropping this closely watched interest-rate signal, which many market participants take as a sign rates won’t go up for at least six months.
“It’s clearer that we’re closer to getting rid of that than we were a few months ago,” Fed Vice Chairman Stanley Fischer said in an interview with The Wall Street Journal last week. New York Fed President William Dudley has avoided using the “considerable time” phrase in recent speeches and instead said the Fed should be “patient” before raising rates.
The Fed has been running simulations on how fast and how much it is likely to increase the U.S. interest rates it controls. The chart below shows the results of their simulations.
In this chart, the green curve for the 2014 simulation, based on the Fed’s most recently run simulations, represents what the Fed today would believe is the most desirable future trajectory for interest rates, which would have interest rates begin rising immediately and very rapidly from near 0% to 4% in the next three years before stabilizing a bit below that level.
However, the blue trajectory for the Fed’s 2012 simulation can be considered to represent the path the Fed will most likely take in hiking interest rates, based on statements made by Fed Chair Janet Yellen and other senior officials. Here, we see interest rates begin rising from near 0% in mid-2015 to a peak near 5% over the next five years before stabilizing.
These interest rates matter for the U.S. national debt because of how it is structured. Over the next five years, over 72% of the public debt that has been issued by the U.S. government will mature and have to be rolled over at much higher interest rates than they are today.
And that means that the portion of the federal government’s annual budget that goes toward paying the net interest on the national debt to the nation’s lenders will increase dramatically if the Fed executes its plan to increase interest rates. The Mercatus Center’s chart below shows how that fits in to the federal government’s projected spending over the next 10 years.
Veronique de Rugy describes the Congressional Budget Office’s projections for the net interest that must be paid on the national debt, and spells out the bottom line:
Spending on net interest payments constitutes the largest single categorical increase. In 2013, interest payments equaled roughly $221 billion. CBO projects that interest payments will steadily grow at an average annual rate of 11 percent to $722 billion by 2024, a 227 percent increase.
These charts show that the federal government will not be able to provide the same level of services without significant reforms to entitlement programs that drive the bulk of spending and compound future interest payments on the federal debt.
And now you know why!