Q&A – If the Fed Cut Interest Rates, What Would the Impact Be on Debt?

Q&A – If the Fed Cut Interest Rates, What Would the Impact Be on Federal Debt? 

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Today’s Entry: Brian, one of the arguments President Trump often states for the Federal Reserve cutting interest rates is that the U.S. would pay less in debt, and thus the federal deficit would be less if interest rates were lower. How big of an impact would there be on the federal deficit if interest rates were as low as they were in his first term? Thank you. 

Bottom Line: This is an excellent question that comes with a slightly more complicated answer than you might be led to think. As consumers, when we think of the impact of what a lower interest rate would mean, we tend to think in terms of how it impacts us. For example, if the Federal Reserve cuts the Fed funds rate that it charges banks for the money they lend out, we know credit card interest rates are lowered, and if we take out a new loan say for a car or a mortgage those rates will likely be lower as well. And speaking of mortgages, if mortgage rates trend lower, we’re aware that they can be refinanced at lower mortgage rates which can provide immediate cost savings for us. So, for those types of reasons, we may be inclined to think it would have a similar impact with the federal government when it’s servicing the federal debt. However, it’s not that straight forward or easy.  

There are two truisms when it comes to lower interest rates regarding the servicing of federal debt. 1) Lower interest rates do reduce the cost of servicing the debt however, 2) Lower interest rates impact the cost of borrowing going forward, not existing obligations. The way the federal government goes about issuing debt to fund deficits is through issuing these products: 

• Treasury Bills (T-Bills): Short-term securities with maturities of a year or less.  
• Treasury Notes (T-Notes): Intermediate-term securities with maturities of 2, 3, 5, 7, or 10 years.  
• Treasury Bonds (T-Bonds): Longer-term securities, historically with 30-year maturities but now also offered in 20-year terms.  
• Treasury Inflation-Protected Securities (TIPS): Debt securities where the principal is adjusted based on inflation, with maturities of 5, 10, or 30 years. 

When you buy/invest in those products, you’re promised the going interest rate at that time for the duration of the length of the product. So, unlike your ability to refinance your debt when rates go down, the federal government realizes the savings from the issuance of new debt at lower interest rates, when higher interest debt investments mature and have been paid off. Here’s how this all comes together in addressing today’s Q&A. 

Despite the Federal Reserve’s interest rate currently being 4.25% to 4.5%, the average interest rate on the greater than $36 trillion in debt owed, is 3.3% due to most of the debt having been issued at lower interest rates. Therefore, currently, every time the Treasury issues debt with an interest rate that’s higher than 3.3%, the average cost of servicing the national debt rises. We need interest rates to fall below 3.3% to begin to realize net savings on the cumulative borrowing costs.  

Based on the current average interest rate of 3.3%, the annual interest expense is about $1.2 trillion per year going forward. If interest rates were as low as they were during President Trump’s first term, when the rate averaged 1.75%, the year one savings would be approximately $186 billion, based on the current federal debt level. If those lower rates could be maintained – the eventual savings would equal approximately $562 billion per year. So, it is a big chunk of change we’re talking about here. The added interest expense is the equivalent of greater than 8% of total federal spending most recently.  

So, as we’re looking for long term fiscal stability by the federal government – President Trump is correct that low interest rates are a huge part of the puzzle, however it wouldn’t be a quick fix or a long-term panacea without other factors weighing in. However, if lower interest rates were obtained and maintained along with an economy growing faster than what we’ve seen, or has recently been projected, as was the case during President Trump’s first term, it may be possible to turn the tide on the federal debt and deficit. Especially based on what we saw with the federal government unexpectedly posting a budget surplus two out of the previous three months.