December 2, 2016

What Would Change Interest Rates?

Series Information

This essay is the fourth in a twelve-essay colloquium on the effect of low interest rates on the economy. To read other essays in the series, click here.

What are the fiscal implications of low interest rates, and what would be the implications of a sharp rise in rates? Low interest rates make it easier for the United States and other countries to service a large debt. A government’s interest expense as a percentage of GDP is approximately equal to the debt-to-GDP ratio times the average interest rate on government debt.

For the United States, which has a debt-to-GDP ratio of about 100 percent, each percentage point increase in the interest rate causes the interest expense to go up by 1 percent of GDP. For Japan, which has a debt-to-GDP ratio of more than 200 percent, each percentage point increase in the interest rate would cause its interest expense to rise by 2 percent of GDP.

About one-third of the US debt is held by the Federal Reserve, and an increase in interest rates does not directly affect the cost to the Treasury of funding this debt. However, it does indirectly affect the cost because the Fed backs its holdings of debt with reserves that it credits to banks, and the Fed pays interest, which is currently at a rate of just 0.25 percent per year. As interest rates rise, the Fed will have to raise this rate so it can persuade banks to keep holding those reserves. The higher its interest cost, the smaller the difference between the interest the Fed receives on its long-term bonds and the interest it will have to pay on bank reserves.

With almost $4 trillion of the Fed’s $4.5 trillion in assets consisting of securities that mature in more than one year, its profits are poised to plummet if its interest expense rises, thereby reducing or eliminating altogether the Fed’s remittances to the Treasury. If we take this potential problem into account, the fact that debt is held by the Fed does not actually insulate the Treasury from interest rate swings. Thus, the appropriate ratio is the total debt relative to GDP, not just the debt held by the public relative to GDP.

However, interest rates do not go up for no reason. The fiscal effect of an interest rate change depends on the source for that change. The source could be an increase in real economic growth, an increase in inflation, or an increase in the risk premium that investors assign to government securities. This essay addresses each of those possibilities.

An Increase in Real Economic Growth

Any increase in real economic growth would likely be caused by an increase in the return to capital. As the return to capital rises, investment increases, and this change raises interest rates. A surge in real economic growth would be favorable for the fiscal outlook; interest expense as a percentage of GDP would rise, but GDP itself would also increase. This increase is particularly significant for the United States, where the current outstanding debt is dwarfed by the unfunded future liabilities embedded in Social Security and Medicare. A faster growth rate would produce a higher tax base for meeting such liabilities as they come due.

An Increase in Inflation

Because interest rates tend to rise along with increased expectations of inflation, consumers and businesses face a choice between making purchases now or postponing purchases into the future. If they expect prices to rise rapidly, their incentive is to make purchases sooner rather than later. This move increases the demand for borrowing and lowers the supply of saving, until interest rates have gone up sufficiently to balance demand and supply.

One standard theory, often attributed to Irving Fisher, is that every percentage point increase in expected inflation is accompanied by an equal increase in nominal interest rates, leaving the real interest rate constant. Expectations of inflation closely align with actual inflation experience. Thus, we should think in terms of a scenario in which both actual and expected inflation rise by a given amount.

A rise in interest rates caused by an increase in inflation would have little effect on the US fiscal position. However, it is true that at the point of inflation increase, there will be an effect on any past long-term debt securities that were issued when inflation expectations were lower. The result is that nominal GDP goes up, and—as a percentage of nominal GDP—the interest expense on this legacy long-term debt goes down.

The fiscal benefits of a jump in inflation are attenuated by several important considerations. Some of the US Treasury’s gain from unexpected inflation would be offset by losses at the Fed because the Fed uses short-term funds to back its holdings of long-term securities.

Moreover, the unfunded future liabilities that are embedded in entitlement programs would tend to go up with inflation. Social Security benefits are indexed to inflation, which means that as inflation rises, the unfunded liabilities of the Social Security system rise as well. Remember that as inflation increases, the prices of healthcare services are likely to increase. This change will raise expenditures in Medicare, the other major program with unfunded liabilities.

Overall, to a first approximation, a rise in interest rates resulting from an increase in inflation would be neutral with respect to the fiscal outlook. If the fiscal outlook improves at all, it will be by much less than would be the case with higher real economic growth.

An Increase in the Risk Premium

Another scenario in which interest rates could rise would be an increase in the risk premium for government debt. Such an increase would likely be sudden and unexpected. It might be caused, for example, by a crisis in another country, such as Japan, with a high debt ratio. Such a crisis might lead to talk of default or debt restructuring, which, in turn, could lead investors to reduce their holding of sovereign debt in any country with an unsustainable fiscal path, including the United States.

A rise in interest rates resulting from an increase in the risk premium would cause interest expense to go up without any compensating increase in GDP. Thus, the rise would be a pure negative for the fiscal outlook. Moreover, it could trigger a vicious cycle: a rise in the risk premium could darken the fiscal outlook, which could cause a further rise in the risk premium, thereby leading to a worse fiscal outlook, and so forth.

In an earlier paper, I argued that this sort of vicious cycle could play out so rapidly that it would represent a “regime shift” from a state of high confidence to a state of low confidence. As a result, the United States would suddenly find itself deep in a fiscal crisis.


The fiscal effect of a rise in interest rates would depend on the source of the increase. Higher returns to investment and higher real GDP growth would be favorable to the fiscal outlook, but a higher inflation rate would be essentially neutral to the fiscal outlook. An increase in the risk premium on government debt could be devastating to the fiscal outlook.