Home > Deficit Commission, Fiscal Cliff, Fiscal Policy, Government Deficit, Obamacare > Interest Rates and the Government Deficit

Interest Rates and the Government Deficit

News reports on the federal government‘s deficit have informed the public that the deficit has declined (go to the Treasury’s Financial Management Service for the actual numbers). There are two issues that the public should bear in mind when thinking about these press reports.

One is that a major fundamental driver of the deficit is the demographic change in the country, specifically the aging  and retirement of the baby boomers. That process continues and so the deficit will continue to grow as more of the boomers retire. The deficit’s decline is only temporary and due to the tax increases imposed by Obamacare among other reasons.

Second, it has also been reported that U.S. interest rates have increased although they are still below historic levels. Short-term interest rates, meaning the interest rates on borrowing by the government over short time periods such as six months, tend to have lower interest rates than borrowing done over longer time periods. So when the government borrows short term, it makes lower interest payments to bond holders and thus reduces the deficit from what it would otherwise be if borrowing were done longer term. However, the risk to the government is that if interest rates go up, then when the short-term bonds mature and must be paid off, the government will need to issue new short-term bonds paying the new higher interest rates so the government’s deficit will rise. If the government borrowed longer term, it would not need to issue new bonds at the higher rates and so the deficit would not increase, at least for a time, until the long-term bonds mature and must be paid off. So this scenario tells us that the decline in the deficit is temporary and will be reversed when the government borrows again.

The message to the public is clear; the deficit is still going to grow. The federal government’s fiscal crisis is still with us, no matter the temporary decline that has occurred.

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Economics One

A blog by John B. Taylor

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One economist's views on economic policy.

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