Interest rates

Interest Rates and the First Hole Rule: Fiscal Policy in the Face of Rising Rates

The Peter G. Peterson Foundation is a think tank focused on tax challenges for America’s future. To that end, the Foundation invites experts from across the political spectrum to contribute their perspectives on the challenges the United States faces as a result of its fiscal policies. Specifically, they asked them to answer two questions:

  1. What is the impact of inflation and rising interest rates on our country’s financial outlook?
  2. How to use fiscal policy in this period of high inflation?

Brian Riedl contributed a very timely essay on the subject of how rising interest rates threaten Washington’s solvency. In the following excerpt, he outlines the fundamental issues that are leading to yet another fiscal crisis for Americans:

In recent years, short-sighted lawmakers, economists and columnists have demanded that Congress take advantage of low interest rates by engaging in a massive borrowing spree. Indeed, President Biden’s huge spending program was often justified by low interest rates on government borrowing.

But this case never made sense for two reasons. First, Washington was already expected to add $100 trillion in core deficits over the next three decades, mostly due to Social Security and Medicare deficits. Even with low rates, the Congressional Budget Office (CBO) projected that interest costs would become the most expensive line item in the federal budget and consume half of all tax revenue within decades. Additional loans would dig the hole.

Second, Washington has never blocked recent low interest rates. Indeed, the average maturity of federal debt has fallen to 62 months. If interest rates rise any time in the future, almost all of the growing national debt would affect those rates within a decade. Therefore, continued heavy federal government borrowing means betting on America’s economic future in the hope that interest rates will never rise again in the future. And there’s no back-up plan if rates go up.

Today’s interest rate hike

It is no coincidence that today’s inflation began to accelerate with President Biden’s overspending through the American Rescue Plan Act. Fueled by President Biden’s poor fiscal policies, inflation spiraled out of control and the Federal Reserve’s monetary policies quickly lagged the price rise curve. Now they are rushing to raise interest rates to slow down the US economy due to the need to reduce inflation.

This is the brief summary of why the Federal Reserve is now engaged in a series of interest rate hikes and is sending signals that it is going to raise them much higher than it has been until now. now. The cost of borrowing is rising rapidly as the Federal Reserve thwarts the inflationary effects of President Biden’s continued spending spree.

Maybe it’s not that bad, except the Federal Reserve isn’t getting help from the Biden administration or the US Congress. Instead, it’s quite the opposite.

There’s an old saying about the first hole rule: “When you’re in one stop to dig.” Riedl offers a basic policy prescription to redress the situation:

The current inflation spurt that has shocked economists and markets should remind policymakers that markets are indeed unpredictable. The President and Congress cannot easily control inflation or future interest rates, but they can influence the size of the federal debt that will be subject to those rates. With the possibility that standard swings in interest rates will push budget deficits to nearly $3 trillion within a decade, lawmakers should craft responsible fiscal policy based on gradual and sustained deficit reduction and keeping an eye on keeping inflation low.

The easiest and least painful way to do this is to set the growth of government spending at a slower rate than the historical growth of government tax revenues. It’s not a difficult concept. Except perhaps for politicians who never learned the first gap rule when it comes to overspending.