Why a Fed rate pause won’t give Biden a break

Federal Reserve Chair Jerome Powell might be done raising interest rates, but that doesn’t mean rates won’t continue to rise.

That’s because the U.S. government has been borrowing a lot of money — $1 trillion last quarter alone — and will continue to need much more, which it will have to obtain at higher rates, thanks to the Fed. That will only further fuel deficits and the debt as investors charge the U.S. government even more to hold the growing supply of Treasury securities.

People are “taking a harder look at the budget in general and the fiscal situation in general and realizing this sort of borrowing is likely to continue in perpetuity,” said Donald Schneider, deputy head of U.S. policy at Piper Sandler.

The central bank is expected to hold rates steady at its meeting on Wednesday as inflation shows signs of leveling off. But markets are increasingly demanding a premium beyond rate increases by the Fed. Those higher borrowing costs could put a drag on the economy, just as the election year gets underway.

That's likely to put pressure on President Joe Biden and Democrats in Congress to reduce deficits, though they’re not even close to reaching a deal with Republicans. And market experts generally cite political dysfunction as a prime reason why they’ve become more pessimistic about the fiscal outlook.

“The Democratic leadership and now GOP leadership in the form of [Donald] Trump have no interest in addressing the actual drivers of our debt,” Schneider said.

The U.S. Treasury’s borrowing plans have come into sharp focus this week after the department announced its latest estimates ($776 billion for the last three months of the year and $816 billion in the first three months of 2024). The updates come as the federal government is again in danger of shutting down this month as Congress tussles over spending.

To be sure, deficit concerns are far from the only factor behind rising yields. Indeed, much of it seems to simply be a mechanical reaction to more supply and fewer buyers — thanks again, in part, to the Fed. With the U.S. central bank shrinking its own holdings of Treasury securities — it held more than $5.7 trillion at its height last year — and less appetite for American debt abroad, domestic investors are buying the bulk of the debt that the U.S. is churning out. Fewer buyers means higher yields.

Not everyone's alarmed. Bobby Kogan, a former staffer at Biden’s Office of Management and Budget, sees no reason to panic about the debt. He said the data suggests it’s easier now to get the debt under control than it was under former President George W. Bush, citing the shrinking of the so-called fiscal gap. The fiscal gap refers to how much deficit reduction you’d have to do each year, as a percentage of GDP, to stabilize the debt. Under Bush, it was estimated to be between 4 percent and 6 percent, whereas now it’s only 2 percent, he said.

“If I were freaking out about debt, I would’ve been freaking out much earlier than six months ago,” said Kogan, now senior director of Federal Budget Policy at the Center for American Progress.

Whether that dynamic holds will depend on how long rates stay high. And the Fed’s moves and the fiscal outlook are inextricably linked. If the central bank holds rates higher for longer, as markets increasingly expect, that means a higher volume of debt. And if rates rise further on U.S. government debt in response to all that supply, that has the effect of slowing economic activity, just as the Fed’s policy does. It could even head off the need for further rate hikes, as many central bank officials have acknowledged.

That puts a focus on the economy’s resilience, which will determine the outlook for inflation and, therefore, how long rates will stay as high as they are now, or higher.

Subadra Rajappa, head of U.S. rates strategy at Societe Generale, said she doesn’t expect yields to increase much further, but “it’s really hard to know at what point it’s going to stop.”