Fed rate hike could add $2.1 trillion to federal deficits, analysis finds

The Federal Reserve hiked interest rates by 0.75% on Wednesday, making an aggressive move to tame inflation that could have other side effects — including a possible recession. The rate increase could also explode federal deficits even further in the years ahead.

A new analysis from the budget hawks at The Committee for a Responsible Federal Budget (CRFB) predicts this week’s rate hike alone will add $2.1 trillion to government deficits over the next decade.

That’s on top of a series of hikes we’ve already seen this year that are already set to add trillions more to the deficit in coming years. The central bank concluded its two-day policy meeting Wednesday by suggesting it could hike rates further in the months ahead.

To be sure, the deficit impact is far from the most pressing concern for policymakers focused on inflation. It nonetheless is a significant factor likely to challenge the Federal Reserve and fiscal policymakers as they try to navigate a “soft landing” that brings down the inflation rate without triggering a recession.

“The irresponsible fiscal policy [of recent years] has made the job of the Federal Reserve many times more difficult," Maya MacGuineas, the president of the CRFB, told Yahoo Finance earlier this week. This challenge, she added, “makes the chance of a recession even more likely.”

The national debt — the total amount of money the U.S. government owes — sits at nearly $31 trillion. Meanwhile, the U.S. has a $1 trillion annual budget deficit, which is the amount of money the U.S. must borrow each year to pay for its expenses. Interest payments on the debt itself are projected to be the fastest-growing part of the federal budget in the years ahead.

“It's as though they're now walking on two different tight ropes at once,” MacGuineas says of the Federal Reserve’s challenges to curb inflation without inflaming the debt even further.

A range of other economists weighed in this week on Yahoo Finance on the chances of a soft landing for the economy on the eve of the Fed’s latest decision. Vanguard Senior International Economist Andrew Patterson said Tuesday that a Fed-induced recession could be hard to avoid in 2023 but the coming downturn “is, based on the data, likely to be somewhat more mild in nature.”

Citi U.S. Wealth Management Head of Investment Strategy Shawn Snyder added that if the economy sees signs of recession, such as consecutive monthly job losses, in coming months that could put the Fed "in a more difficult place, and I think that will put them in perhaps a holding pattern."

The federal funds rate and the national debt

Back in the early 1980s, then-Federal Reserve Chair Paul Volcker led the charge against inflation. While the central bank’s benchmark interest rate had soared to the teens back then, Volcker had an advantage because the government debt then constituted just around 30% of GDP.

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

On Wednesday, officials raised the federal funds rate to a range of 3.0% to 3.25% as part of an effort to bring inflation down from its current level of 8.3%. The move marked a third-straight 75-basis-point rate hike since June and brings rates to their highest level since 2008.

In June, the CRFB analyzed the rate hikes up to that point and projected that annual interest costs will triple by 2032, up from nearly $400 billion now to $1.2 trillion next decade. The total costs were projected to be $8.1 trillion over the next decade. "In reality, however, interest rates — and in turn interest costs — could be even higher," the authors added.

In the days ahead, economic observers will watch closely for hints from the Fed of how much further it will raise interest rates in the months ahead.

‘Two very reckless periods of excess borrowing’

Speaking to Yahoo Finance, MacGuineas blamed the overall debt situation on spending binges from lawmakers in both parties. She acknowledged the importance of spending trillions spent to combat COVID. But, she added, “That was sandwiched in between two very reckless periods of excess borrowing when we shouldn't have.”

The Tax Cuts and Jobs Act of 2017 signed by then-President Trump and more recent spending from the Biden administration have both driven current record-breaking deficits, she said. Her group has recently criticized Biden’s executive order to forgive student loans, projecting it will add around half a trillion dollars to the already sky-high deficits.

In recent years, policymakers in both parties have downplayed debt concerns. Republicans have long argued that the 2017 tax cuts would pay for themselves, though that has not proven to be the case. Meanwhile, Democrats contend that deficits don’t matter; some cite the unorthodox economic principle known as Modern Monetary Theory, which posits the government can avoid the consequences of debt because it can print more money.

“All of these arguments seduce politicians into believing they don't have to pay for things,” MacGuineas said. These theories, she added, have "given a permission slip to politicians who are all too eager to grab it.”

This post has been updated with information about the Fed's decision.

Ben Werschkul is a Washington correspondent for Yahoo Finance.

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