By Dr. Christopher Douglas
Other recent news items overshadowed what should have been a significant headline: the interest rate on current 30-year Treasury bonds reached 5% in July. Interest rates on shorter-term Treasuries also rose from 4% to 4.5%. These interest rates represent what the government pays when it borrows money for a specific period of time.
Treasury interest rates may seem esoteric, but they impact Americans in two direct ways.
First, other interest rates tend to follow Treasury interest rates. Loaning money to the government is a safe way for a lender to earn interest because the federal government has never defaulted on its loans. In contrast, when a lender provides money to a borrower to buy a house, car or other item, there is a risk the borrower will default. Lenders must be compensated for this risk through a higher interest rate; otherwise, they will not be willing to make these loans.
Higher interest rates and higher government spending compound the fiscal challenges facing the federal government.
Thus, the Treasury interest rate establishes a floor on the interest rates private borrowers pay. No one would be willing to extend a 30-year mortgage for less than a 5% interest rate if they could earn 5% simply by buying a 30-year Treasury bond.
Second, higher Treasury interest rates increase the national debt, worsening the U.S. fiscal position. The federal government repays debt that comes due by borrowing more money, a process known as “rolling over the debt.” The national debt currently held by the public is $31 trillion, and approximately one-third of it, or $10.5 trillion, comes due each year.
The average interest rate on U.S. debt is about 3.4%. If the Treasury must roll over this debt at an interest rate that is one percentage point higher, it adds roughly $100 billion in annual interest costs to the federal budget, which then adds to the national debt. This is on top of the roughly $2 trillion annual budget deficit the federal government runs. Financing that new borrowing at an interest rate of 4% adds another $80 billion in annual interest costs, further increasing the annual deficit. Thus, higher interest rates and higher government spending compound the fiscal challenges facing the federal government.
There are three likely reasons why Treasury rates are increasing.
First, as the government continues to borrow, it must offer higher interest rates to entice lenders to continue lending.
Second, as the debt increases, lenders may demand a higher interest rate as compensation because of concerns that the government could have difficulty repaying what it has borrowed.
Third, lenders require an interest rate that exceeds the rate of inflation as compensation for the loss of purchasing power over the life of the loan, and inflation remains elevated.
People often wonder when interest rates will fall back to where they were before 2022. Although interest rates are difficult to forecast, my belief is that they will not decline until both inflation and government borrowing fall.
Dr. Christopher Douglas came to the University of Michigan-Flint in 2006. He earned a B.S. in Electrical Engineering and a B.S. in Economics from Michigan Technological University in 2001, and his Ph.D. in Economics from Michigan State University in 2007. As Professor of Economics, he teaches Principles of Microeconomics, Principles of Macroeconomics, International Economics, Public Finance and Sports Economics.
