How the Fed's inflation fight inflames the national debt

The Federal Reserve’s fight against inflation is adding fuel to the national debt as the central bank prepares to keep interest rates higher for longer.

While inflation has plummeted since the Fed hiked rates to a two-decade high last year, officials are still not comfortable with how quickly prices are rising. Fed officials expect to cut rates once before the end of the year, which would set the baseline borrowing range at 5 percent to 5.25 percent.

Those higher Fed interest rates will also force the federal government to borrow money at a higher cost. As government spending is projected to climb over the next decade, the amount of interest the nation pays on its multitrillion-dollar debt is on track to surpass defense spending.

“It’s not the only factor, but it is a factor contributing to our deficits,” said Joseph Gagnon, senior fellow at the Peterson Institute for International Economics, in an interview.

“But the funny thing is … the large deficits themselves are helping to force the Fed to keep interest rates high, because they're just supporting a lot of spending,” he continued. 

Recent figures from the Congressional Budget Office (CBO) project the debt held by the public, which stands at more than $27 trillion, soaring over the next decade, relative to the size of the nation’s economy, going from 99 percent of the gross domestic product (GDP) in fiscal 2024 to 122 percent in 10 years. 

While experts have pinned much of the projected increase to spending, some have also said the Fed’s inflation fight is also adding to the pot. 

“The government is spending a lot of money and it's not taking taxes away from people. So they're still spending too, and it's too much for the economy” Gagnon said.

The Fed first hiked rates in 2022 after setting them close to zero during the coronavirus pandemic — when government spending also climbed as the government passed a significant amount of coronavirus relief — to help keep the economy afloat. 

The aim behind hiking rates is to tamp down on demand by discouraging consumers from borrowing. Experts say borrowing can also be more expensive for the government, but that doesn’t mean that it responds the same way as consumers. 

“It's a little different from when you go to buy a car and you say, well, it's 10 percent interest rate is too high, I can't afford this new car,” Gagnon said.

“If Congress passed a law that says we have to spend so much and the tax rate is x, then that doesn't respond to interest rates, initially,” he said. “But if interest rates raise the deficit over time, and Congress says, ‘Wait a minute, this deficit’s too high,’ then maybe they will cut the deficit.”

The CBO projects interest payments to hit $892 billion in 2024, exceeding annual defense spending, and eventually $1.7 trillion in 2034, “at which point they would nearly equal projected outlays for Medicare,” the report stated.

At the same time, however, the office notes it expects the Fed to lower interest rates in 2025 in its forecast, which some say underlines the government’s spending. 

“The interest costs of the debt are the product of interest rates and the amount of money that the government is borrowing,” said David Wessel, senior economic studies fellow at the Brookings Institution, in an interview. “And the bigger factor is the amount of money the government's borrowing, and that's the real reason that that interest as a share of GDP is going up.”

“Obviously, to the extent that the Fed raising interest rates, short-term interest rates, contributes to the bond market pushing up long term-interest rates, that does make borrowing more expensive. That's true,” he said. But he added, “The big factor is not what the Fed does.”

Another driver federal analysts cite behind the nation’s projected debt trajectory is mandatory spending, particularly as costs for Social Security and Medicare are on the rise. The CBO estimates that, relative to GDP, outlays for mandatory programs will “increase from 14.7 percent in 2024 to 15.3 percent in 2034.”

“Two underlying trends, the rising average age of the population (referred to as the aging of the population) and growth in federal health care costs per beneficiary, contribute to that increase,” the CBO said. 

Budget hawks and experts have pointed to the forecast as a warning call to Washington as both sides remain deeply divided on how to tackle the country’s deficits. 

“I think it's highly dangerous. I think that the fact that interest cost of the debt, really, as a share of GDP really hadn't risen for about 40 years, by much, gave Congress an excuse not to address the debt,” said Eugene Steuerle, fellow and the Richard B. Fisher chair at the Urban Institute, adding that the “interest costs clearly adds substantially to the pressure on Congress to do something about the debt.”

Lawmakers on both sides are already looking to 2025, when Congress faces another potentially nasty fight over the nation’s borrowing limit, which caps how much money the Treasury can owe to cover the country's bills.

Congress last suspended the debt ceiling in 2023, but not until after a high-stakes, partisan months-long fight over spending. The national debt had sat at roughly $31 trillion then, and it since has risen to more than $34 trillion. 

“Eventually, Congress is going to do something. They might do it because there's some kind of a crisis, they might do it because we have an outbreak of leadership, and they might do it because we're getting to the point where the Social Security and Medicare trust funds are about to run out of money,” Wessel said.