US debt: Federal interest payments could soon exceed military spending

The Federal Reserve’s war on inflation isn’t just painful for home buyers and people with credit card debt. Uncle Sam is getting squeezed by higher borrowing costs, too.

The cost to finance America’s growing mountain of debt is rising rapidly as the Fed scrambles to put out the inflation fire by raising interest rates and shrinking its nearly $9 trillion balance sheet.

During fiscal 2022 alone, the federal government made $475 billion in net interest payments, up from $352 billion the prior year, according to the US Treasury Department. For context, that’s more than the government spent on veterans’ benefits and transportation – combined. And it’s nearly as much as the $677 billion spent on education.

By 2025 or 2026, the United States may hit a bleak milestone: Federal interest payments could exceed the country’s entire defense budget, according to Moody’s Analytics. For context, defense spending stood at $767 billion in fiscal 2022.

Although there’s little reason to doubt Washington’s ability to make interest payments, the surging cost to finance America’s $31 trillion in debt leaves less room for Congress to spend on other priorities, including everything from infrastructure and the climate crisis to the military.

“Regardless of who wins the midterms or in 2024, there are really difficult decisions that will have to be made. This is really going to handcuff them,” said Moody’s Analytics economist Dan White.

No more easy money

For many years, Washington was able to borrow nearly for free. The Fed kept interest rates very low to stimulate growth (and encourage inflation) and investors around the world clamored to buy US debt. This situation made it easy and affordable for Congress and the Trump and Biden administrations to borrow aggressively.

But the situation changed beginning in the spring of 2021 as inflation began to surge in the United States and in many other major economies. The Fed was forced to eventually pivot from emergency stimulus mode to inflation-fighting mode, a shift that even Fed officials concede happened too late, with the benefit of hindsight.

With inflation proving to be very stubborn, the Fed has already raised interest rates by three percentage points so far this year. Another jumbo-sized interest rate hike is widely expected on Wednesday when the Fed concludes its latest policy meeting, and another half a percentage point hike in December. That would lift rates to 4.5% — up from near zero at the start of this year.

All of this will make it that much more expensive to finance US debt going forward.

“Low rates, a consequence of low inflation, are an enabler. But high inflation is kryptonite to easy money policy and excessive spending,” said Peter Boockvar, chief investment officer at Bleakley Financial Group.

‘A little bit nervous’

Boockvar notes that during the third quarter, federal gross interest payments hit $737 billion on an annualized basis, according to last week’s GDP report. That’s up from $516 billion two years ago and rivals the nearly $800 billion that is expected to be spent on defense in fiscal 2023.

But White of Moody’s notes that gross interest payments include interest the government pays to itself and said net interest is the more relevant category to watch here.

The Congressional Budget Office recently estimated over the summer that net interest payments will exceed defense spending in 2029.

“That made everyone a little bit nervous,” said White.

Persistent inflation and rapidly rising rates have forced forecasters to keep marking up their forecasts for the cost of financing US debt. The CBO said that between July 2021 and May 2022, it has ramped up its projection of interest rate spending through 2031 by $2.5 trillion

Beyond raising interest rates, the Fed is aggressively shrinking the size of its massive balance sheet, which swelled to nearly $9 trillion as the central bank bought up Treasury bonds and other assets. Now the Fed is allowing the balance sheet to shrink by tens of billions of Treasuries each month.

“You’re losing a buyer,” said Boockvar.

And now a possible recession looms

White said the trillions of dollars in debt added during the Trump and Biden administrations has worsened the fiscal situation significantly.

“It fast-forwarded us almost an entire generation,” the Moody’s economist said.

In a best-case scenario, the United States grows its way out of the debt mess, with the economy expanding more rapidly than interest payments.

But White worries that may not be the case — especially with a potential recession around the corner due to the Fed’s war on inflation.

A recession would likely exacerbate the fiscal problems by depressing the amount of tax revenue the government takes in from businesses and individuals while simultaneously increasing government spending on unemployment, food stamps and other social safety net programs.

“A recession could make things even worse,” White said.

Lesson from across the pond

The market turmoil in the UK — and sudden collapse of the Truss government — could prove to be a cautionary tale. Bond yields spiked in the UK after former Prime Minister Liz Truss unveiled a budget proposal that unnerved investors.

“The UK bond market had a hissy fit. With interest rates going up, the sovereign bond bubble is unwinding,” Boockvar said.

Of course, the United States is still the world’s largest economy and remains a top destination for foreign investment. And the US dollar is the world’s reserve currency.

All of those factors should help ease the burden of high debt.

“We will always be able to pay our debt because we have a printing press,” Boockvar said. “The question is what the interest rate will be on that debt.”

The answer to that question has global ramifications because US bonds are widely viewed as the safest assets on the planet. They help set the cost of capital on everything from stocks and mortgages to emerging market debt.

“For decades, budget deficits didn’t matter and US debt didn’t matter,” said Boockvar. “Maybe all of a sudden they will.”

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