A new analysis reveals that a Fed rate hike could add $2.1 trillion to the federal deficit

The Fed’s widely expected move to raise interest rates on Wednesday is aimed at taming inflation, but it could have other side effects — including a potential recession. It turns out that a rate hike could also increase the federal deficit in the coming years.

New analysis from budget hawks at the Committee on Responsible Federal Budget (CRFB) predicts that this week’s expected three-quarters of a percentage point rate hike – by itself – will add $2.1 trillion to the government’s deficit over the next decade.

This is on top of a series of hikes we’ve already seen this year that have already added trillions in costs. The central bank concludes its two-day policy meeting on Wednesday with more rate hikes likely in the coming months.

To be sure, the effect of the deficit is a far cry from the most pressing concern of policy makers who focus on inflation. However, this is an important factor that is likely to challenge the Federal Reserve and fiscal policy makers as they attempt to traverse a “soft landing” that will bring down the inflation rate without causing a recession.

‘Irresponsible fiscal policy [of recent years] This challenge, Maya McGuinness, president of CRFB, told Yahoo Finance this week, “increases the potential for a recession.”

Marriner S. Eccles Federal Reserve Building in Washington, D.C. in June. (Reuters/ Sarah Selbiger)

The national debt – the total amount of money the US government owes – is about $31 trillion. Meanwhile, the United States runs an annual budget deficit of $1 trillion, the amount of money the United States has to borrow each year to pay for its expenditures. Interest payments on the debt itself are expected to be the fastest growing part of the federal budget in the coming years.

“It’s as if they are now walking two different tightropes at once,” McGuinness says of the Fed’s challenges to curb inflation without further fanning the debt.

This week a group of other economists weighed on Yahoo Finance about the prospects for a soft landing for the economy on the eve of the Federal Reserve’s latest decision. Andrew Patterson, Vanguard’s chief international economist, said Tuesday that a Fed-caused recession may be hard to avoid in 2023, but that the next downturn “based on the data, is likely to be somewhat milder in nature.”

Shaun Snyder, Citi’s head of investment strategy at Wealth Management, added that if the economy sees signs of recession, such as back-to-back monthly job losses, in the coming months, that could put the Fed “in a much more difficult place, and I think that will put them in perhaps a wait-and-see pattern.” “.

Federal Funds and National Debt Rate

Back in the early 1980s, then-Fed Chairman Paul Volcker led the charge against inflation. While the central bank’s benchmark interest rate was raised to teens at the time, Volcker had an advantage because government debt at the time made up about 30% of GDP.

Today, total debt has ballooned to about 120% of GDP.

On Wednesday, officials are expected to raise the federal funds rate to a range of 3.0% to 3.25% as part of an effort to bring down inflation from its current level of 8.3%. The move would mark a 75 basis point rate hike in a row since June and raise rates to their highest level since 2008.

In June, CRFB analyzed the price hike up to that point and projected that annual interest costs would triple by 2032, from about $400 billion now to $1.2 trillion in the next decade. Total costs were projected to be $8.1 trillion over the next decade. “In reality, however, interest rates – and therefore interest costs – could be even higher,” the authors added.

Economic watchers will be watching closely for hints from the Federal Reserve about how much interest rates will rise in the coming months, either from comments by incumbent President Jerome Powell or when the Fed releases a summary of interest rate expectations known as a “point chart.”

Two reckless periods of excess borrowing

Speaking to Yahoo Finance, MacGuineas blamed putting debt on excessive spending from lawmakers in both parties. She acknowledged the importance of spending trillions to combat the Corona virus. But, she added, “It was caught between two very reckless periods of excessive borrowing when we shouldn’t.”

She said the Tax Cuts and Jobs Act of 2017 signed by then-President Trump and more recent spending from the Biden administration had led to a record deficit today. Her group recently criticized Biden’s executive order forgiving student loans, predicting that it would add about half a trillion dollars to an already high deficit.

WASHINGTON, DC - DECEMBER 20: US President Donald Trump hosted an event to celebrate Congress' passage of the Tax Cuts and Jobs Act with Republican members of the House and Senate on the South Lawn of the White House on December 20, 2017 in Washington, DC.  The tax bill is the first major legislative victory for the Republican- and Trump-controlled Congress since taking office nearly a year ago.  (Photo by Chip Somodevila/Getty Images)

Then-US President Donald Trump hosted an event to celebrate Congress’ passage of the Tax Cuts and Jobs Act on the South Lawn of the White House in 2017. (Chip Somodevilla/Getty Images)

In recent years, policymakers in both parties have downplayed debt concerns. Republicans have long argued that the 2017 tax cuts will pay for themselves, though that hasn’t been proven true. Meanwhile, Democrats maintain that the deficit doesn’t matter. Some cite the unconventional economic principle known as modern monetary theory, which assumes that the government can avoid the consequences of debt because it can print more money.

“All of these arguments tempt politicians to think they don’t have to pay for things,” McGuinness said. These theories, she added, “give a slip of statement to politicians who are all very eager to snatch it up.”

Ben Wershkull is the Yahoo Finance correspondent in Washington.

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