The CBO’s Interest Rate Projections Might Be Too High
March 2, 2015
The Center on Budget and Policy Priorities has been highlighting a significant issue lately: the importance of projected interest rates on our long-term fiscal outlook.
The future is uncertain in general, but in many ways this is especially true for the federal budget. For example, tax revenues and certain outlays, like refundable tax credits, are very sensitive to the business cycle. Interest rates are another big area of uncertainty. The cost to service the national debt could potentially become a very large portion of the federal budget if interest rates increase.
The CBO projects that to happen. It sees the average interest rate on debt climbing to about 3.8% by 2025.
I am less convinced. At the Upshot, the Center’s Jared Bernstein persuasively notes that the federal government has repeatedly been overestimating nominal interest rates for about two decades. Included is a chart showing several of the overestimated trend lines, and comparing them to the actual observed interest rates.
Bernstein also makes a reference to forward rates for the 10-year bond according to bond traders, which imply a low interest rate over the next decade. This was an important point: market expectations are substantially different from the CBO’s projections.
While there’s no perfect market forecast of the average interest rate on government borrowing, specifically, the simplest measure of expected long-term interest rates on government debt is the market yield on the 30-year treasury. Theoretically, over the long term, you should expect interest payments to asymptotically approach something close to that long-term value.
Here’s how the CBO’s projection actually stacks up against that benchmark:
As you can see from the chart above, rather than approaching the 2.6% long-term interest rate projected by markets, the CBO has interest quickly rocketing past it. There’s a substantial, 1.2% gap between the long-term interest rate the CBO has us approaching, and the actual long-term rate being traded in markets.
This is a pretty big contradiction. Investors would be making a horrible mistake if they bought long-term bonds at a 2.6% rate and then, only a few years later, discovered the existence of bonds trading at a far-superior 3.8% yield. Investors don’t like making horrible mistakes. So the only possible conclusion is that investors – like Jared Bernstein, and like me – don’t really believe the CBO’s projections. The actual interest payments, when the time comes, are probably going to be lower than the CBO is forecasting now.
There is an argument to be made for what the CBO is doing, though. It is erring on the side of caution, assuming a less rosy picture of our fiscal situation than the markets do. To some degree this seems fair; it would be a far worse mistake to allow problems to go entirely unchecked.
The interest rates issue is also worth thinking about in the context of the debate over dynamic scoring. We trust the economists employed by the federal government to make big-time projections all the time. General projections on how taxes affect economic output generally would be no different than the kind of projections that these economists already do.
In general, the federal government’s economists are prudent. They aren’t overly-optimistic, they aren’t overly-ideological, and they err on the side of caution. On interest rates, though, they might be a little bit too cautious, and that somewhat overstates the danger and the fiscal costs of deficit-increasing measures, including net tax cuts. As Jared Bernstein writes, “the future is unknowable, but it may be less expensive than we think.”