In preparation for the president’s budget proposal next week, it’s important to discuss one of the assumptions on which all figures will be based.
Over the past few years, interest rates on federal debt have fallen to historically low levels thanks to manipulation by the Fed and risk aversion by markets. An unintended consequence of these low interest rates is that the federal debt has been financed very cheaply. Still, interest payments on federal debt have rising sharply since the end of the Clinton era.
The average maturity of the national debt is just over 62 months. This means that once every five years, almost all of our national debt is refinanced into new contracts. The CBO does its budget projections with this in mind, and guesses at what the interest rates will be. For their most recent projections, they assume interest rates will stay low until they begin to slowly rise until 2014.
This is a big assumption. Any number of things could cause interest rates to rise, from a market shock to another debt ceiling debacle to a debt downgrade and so on. Assuming interest rates don’t stay low, the cost of financing the public debt could rise extremely quickly. The chart below shows the national debt picture 62 months from now under different interest rates.
If interest rates rise to where they were at the end of the Clinton presidency, when the economy was rosy, the federal debt will be $4 trillion higher in five years. It’s amazing what a difference a little assumption can make.