Deficit Spending During Higher Inflation and Interest Rates: Implications for Debt Sustainability

December 18, 2023 R47877

Deficit Spending During Higher Inflation and
December 18, 2023
Interest Rates: Implications for Debt
Lida R. Weinstock
Sustainability
Analyst in Macroeconomic
Policy
Expansionary fiscal policy (an increase in the budget deficit through an increase in government

spending, decrease in tax revenue, or some combination of both) can be an important tool in
stimulating economic activity, particularly as economic growth declines. For example,

unemployment tends to increase during such a downturn, further dampening private spending and
growth. Boosting government spending during such a period can allow employers to hire more employees and pay them
higher wages. Without adequate stimulus, the productive capacity of the economy could be affected in the long term. To do
this effectively, the government must, if already running a budget deficit, increase the size of its deficit and borrow money to
finance that stimulus. Running a budget deficit increases the amount of government debt, and increasing a deficit increases
the rate that debt is growing.
While deficit spending can be an effective policy tool, it also comes with certain potential tradeoffs. Expansionary fiscal
policy is generally thought to have certain outcomes that can reduce its effectiveness in the short term, including crowding
out investment and other interest-sensitive spending, decreasing net exports, and increasing inflation. Persistently applying
fiscal stimulus across the business cycle can negatively affect the economy in the long term. Persistent fiscal stimulus—
particularly during economic expansions—can limit long-term economic growth by crowding out private investment.
Additionally, rising debt requires a growing portion of the federal budget to be directed toward interest payments on the debt,
potentially crowding out government spending on other projects and programs.
Higher interest rates can exacerbate the potential negative effects of deficit spending. They directly increase interest
payments on newly issued debt, in turn increasing net interest outlays and potentially resulting in more borrowing to cover
those increased costs. Higher interest rates can also decrease interest-sensitive spending and net exports in the economy, both
of which work to lower GDP. Higher net interest outlays and slowed GDP growth both result in rising deficit and debt-to-
GDP ratios. While GDP growth has been uneven in recent quarters, net interest outlays and the debt-to-GDP ratio have been
increasing and are expected to continue to rise.
For most of the past 40 years, the federal government has run a budget deficit and added to the stock of publicly held debt.
When compared to the size of the overall economy, the growth of relative size of the deficit and debt has been uneven, rising
and sometimes falling as a result of various changes in economic conditions and tax and spending policies. Notably, in recent
years, both the deficit-to-GDP and debt-to-GDP ratios have grown considerably, largely as a result of spending during the
COVID-19 pandemic. Prior to COVID-19, the downside tradeoffs of deficit spending had arguably not been fully realized,
because inflation and interest rates remained low despite persistent deficits. However, inflation and interest rates are both
higher currently than prior to the pandemic, in part as a result of large deficits and growing debt. As a share of GDP,
servicing the debt has increased since the pandemic and the increase in inflation. Even though some fiscal stimulus has been
removed since 2020, the deficit-to-GDP ratio remains large by historical standards, particularly when compared to other
economic expansions.
These recent changes and trends in economic conditions has brought the question of debt sustainability back to the forefront
of several policy debates. Of particular concern is that the new interest rate environment could accelerate the timeline for
reaching a “tipping point” where GDP growth is persistently and adversely affected or a default on the debt (a scenario in
which the government would not be able to fully pay lenders) becomes imminent.
There is not a consensus among economists about if or at what level a “tipping point” at which debt becomes unsustainable
would occur, but some estimates range from debt-to-GDP ratios of 80% to 200% and beyond. For context, the Congressional
Budget Office currently projects the publicly held debt-to-GDP ratio to reach 100.4% in FY2024 and 180.6% by FY2053.
Recent research into this topic generally points to the current projected path of fiscal policy and publicly held debt to be
eventually unsustainable absent policy action or a change in economic conditions.

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Deficit Spending: Implications for Debt Sustainability

Introduction
In recent years, the U.S. economy has experienced a fundamental shift from the paradigms of
previous decades. Prior to the COVID-19 pandemic, inflation was low and stable despite
conditions that were traditionally thought to spur inflation, including low unemployment, low
interest rates, and periods of large budget deficits—when government spending was much larger
than revenue.1 As the pandemic has receded, inflation and interest rates have seemingly been
more sensitive to these factors. After being persistently low for many years, inflation began rising
in 2021, reaching highs not seen since the 1980s. Partially as a result of this shift in inflation and
the monetary policy response to it, interest rates have also risen. While inflation has come down
from its 2022 peak, it remains higher than its previous trend and above the policy target of 2%.
While the causes of recent inflation are complex and not the result of any one single factor, this
period has caused economists to reconsider the sensitivity of prices to certain phenomena, notably
changes in employment and fiscal and monetary policy.
This report focuses on federal fiscal policy—government spending and tax policy—and how its
effects on the economy have changed (in practice or in perception) in light of higher inflation and
interest rates. This report outlines the ways in which expansionary fiscal policy (i.e., deficit
spending) can be an important economic tool but can also have negative macroeconomic effects
in the short and long run when applied persistently across the business cycle. It then focuses on
recent fiscal trends and projections in the context of current economic conditions, which may be
exacerbating some of the negative effects of persistent deficit spending, helping to further drive
up annual deficits and the debt-to-GDP ratio. This has renewed concerns about the sustainability
of the federal government’s debt and the timeline for potentially reaching a tipping point at which
the level of debt becomes unsustainable. As such, the report concludes with a discussion of the
sustainability of the U.S. fiscal path and the potential tradeoffs and complications faced by
policymakers in terms of decreasing the deficit and debt relative to the size of the economy.
Fiscal Policy and Economic Theory
To stimulate the economy, the government can increase spending, decrease tax revenue, or use
some combination of both.2 Known as expansionary fiscal policy, increases to government
spending or tax cuts increase aggregate demand (total spending). Increasing government spending
directly increases aggregate demand, while tax cuts indirectly increase aggregate demand by
increasing disposable personal income, which in turn increases consumption.3 However, to do
this, the government must increase the size of its budget deficit and borrow money to finance that
stimulus, which will increase the government’s debt.4

1 Brookings Institution, “What’s (Not) Up with Inflation?,” October 3, 2019, https://www.brookings.edu/wp-content/
uploads/2019/10/es_20191003_inflation_transcript.pdf.
2 Some types of stimulus are generally more effective than others. For more details, see CRS Report R45780, Fiscal
Policy Considerations for the Next Recession, by Mark P. Keightley.
3 For more details on fiscal policy and its effects on the economy, see CRS In Focus IF11253, Introduction to U.S.
Economy: Fiscal Policy, by Lida R. Weinstock.
4 If the government is running a budget surplus at the time of spending increases or tax cuts, such policy could be
financed by reducing the size of the surplus or by starting deficit spending and borrowing money, depending on the size
of the stimulus.
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Benefits of Expansionary Fiscal Policy
Expansionary fiscal policy can stimulate economic activity during an economic downturn
(recession), as described above. As the economy shrinks, people lose their jobs and wage growth
slows, further dampening spending and growth. It can be crucial to a recovery to provide stimulus
to boost overall spending, which can occur through either expansionary fiscal or monetary policy.
When spending in the economy increases, employers are able to hire more employees and pay
them higher wages. If not enough stimulus is provided and the recession is deep and long, the
supply of labor, productivity rates, and capital accumulation rates may never fully recover. This
could cause growth in gross domestic product (GDP) to be on a permanently lower trajectory.
The Relationship Between Fiscal Policy and Debt
As discussed previously, a budget deficit occurs when the government’s expenditures are larger than its revenues.
The U.S. government has generally run budget deficits for more than 40 years, with the exception of four years in
the late 1990s and early 2000s, when it ran budget surpluses. A budget surplus occurs when the government
receives more in revenues than it spends in outlays. The budget deficit or surplus is measured in terms of a given
fiscal year.
Federal debt is a measure of how much money the government owes to various debt holders. Budget deficits
increase publicly held federal debt levels as the government borrows money to cover the difference in revenues
and outlays in a given fiscal year.5 As debt increases over time, this can result in further increases in deficit
spending as the government pays interest on its stock of debt.6
Short-Term Risks of Expansionary Fiscal Policy
Expansionary fiscal policy is generally thought to have certain outcomes that can reduce its
effectiveness in the short term, including crowding out investment and other interest-sensitive
spending, decreasing net exports, and increasing inflation.7
Rising Interest Rate Risk
When the government borrows money to finance deficits, it does so from a supply of “loanable
funds,” meaning the money available from savers and investors who choose to lend the money to
the government or private parties. When the government increases its borrowing of these funds,
demand for the funds increases and, subsequently, so does the interest rate (the price of borrowing
the funds). Rising interest rates can crowd out private investment as it becomes more expensive
for firms to borrow and invest in capital.8 Rising interest rates can also decrease interest-sensitive
consumer spending, such as purchases of houses, cars, or large appliances.9 The Federal Reserve
(Fed) can use monetary policy and attempt to offset this, if it desires, by lowering the targeted
federal funds rate, but the Fed’s ability to affect private longer-term interest rates used to finance
investment and consumer durables is limited.

5 This report focuses solely on federal debt that is held by the public and does not include discussion of
intragovernmental debt, which one part of the government owes to another.
6 For more information on the relationship between deficits and debt, see CRS Report R44383, Deficits, Debt, and the
Economy: An Introduction, by Grant A. Driessen. For information on how debt is issued by the Treasury Department,
see CRS Report R40767, How Treasury Issues Debt, by Grant A. Driessen.
7 Benjamin M. Friedman, “Crowding Out or Crowding In? Economic Consequences of Financing Government
Deficits,” Brookings Institution, https://www.brookings.edu/wp-content/uploads/2016/11/1978c_bpea_friedman.pdf.
8 Laurence Ball and Gregory Mankiw, What Do Budget Deficits Do?, National Bureau of Economic Research (NBER),
Working Paper no. 5263, September 1995, https://www.nber.org/system/files/working_papers/w5263/w5263.pdf.
9 Ball and Mankiw, What Do Budget Deficits Do?
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Another potential result of rising interest rates is lower net exports. As domestic rates rise relative
to foreign rates, investors tend to seek out U.S. investments, because the relatively high interest
rates mean relatively high returns on investment. Increased demand for U.S. investment from
foreign investors means that the demand for the dollar would increase as foreign investors
exchanged various foreign currencies for dollars that they could then invest. This increased
demand for dollars increases the value of the dollar, referred to as appreciation. When the dollar
appreciates, it becomes more expensive relative to other currencies—it takes more foreign
currency to “purchase” one dollar—and, therefore, U.S. goods and services become more
expensive relative to foreign goods and services, causing the trade deficit to increase as exports
decrease and imports increase.10 However, this export effect may be tempered as foreign capital
flows into the United States, which can push interest rates back down as the supply of loanable
funds increases, potentially offsetting the initial rise in rates caused by the stimulus.
These offsetting effects from rising interest rates would be expected to be partial such that
stimulus expands aggregate demand on net, and their magnitude depends on the state of the
economy. During a recession, there is less risk of increasing interest rates due to already
depressed demand for investment and interest-sensitive spending. Because demand for loanable
funds is depressed during a recession, the additional demand created by government borrowing
does not increase interest rates as much and therefore does not crowd out as much private
spending or decrease net exports as much as it would during an economic expansion.11
Rising Inflation Risk
The goal of fiscal stimulus is to increase aggregate demand within the economy. However, if
fiscal stimulus is applied too aggressively or is implemented when the economy is already
operating near full capacity, it can result in “overheating,” a situation in which aggregate demand
outstrips aggregate supply. This can cause inflation to accelerate. A rising inflation rate can
introduce distortions into the economy and impose unnecessary costs on individuals and
businesses.12 The Fed can limit the risk of inflation by increasing interest rates, which would
dampen aggregate demand, if there is any sign of the economy overheating. In doing so, the
effects of rising interest rates discussed in the previous section—crowding out investment and
increasing the trade deficit—would be exacerbated, thereby increasing the risk of triggering a
recession.
Risks of Persistent Expansionary Fiscal Policy
Persistently applying fiscal stimulus—running budget deficits—across the business cycle can
negatively affect the economy in the longer term. Persistent fiscal stimulus—particularly during
economic expansions—can limit long-term economic growth by crowding out private investment.
Additionally, rising debt requires a growing portion of the federal budget to be directed toward
interest payments on the debt, potentially crowding out government spending on other programs.
Issues of debt sustainability are discussed in a later section.

10 Olivier Blanchard, Macroeconomics, 5th ed. (Upper Saddle River, NJ: Pearson Education, 2009), pp. 450-451.
11 Alan J. Auerbach and Yuriy Gorodnichenko, “Measuring the Output Responses to Fiscal Policy,” American
Economic Journal: Economic Policy, vol. 4, no. 2 (May 2012), https://www.aeaweb.org/articles/pdf/doi/10.1257/
pol.4.2.1.
12 See, for example, Richard G. Anderson, Inflation’s Economic Cost: How Large? How Certain?, Federal Reserve
Bank of St. Louis, July 2006, https://www.stlouisfed.org/publications/regional-economist/july-2006/inflations-
economic-cost-how-large-how-certain.
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Long-Term Growth
Long-term growth is determined, in part, by the amount of capital in an economy. Persistent fiscal
stimulus, and the associated budget deficits, can decrease the size of the economy in the long term
as a result of decreased investment in physical capital (long-lasting assets used to produce goods
and services).13 As discussed above, the government’s deficit spending can result in higher
interest rates, which generally lead to lower levels of business investment. Physical capital
investment allows businesses to produce more goods and services with the same amount of labor
and raw materials. Government deficits that lead to lower levels of business investment can
therefore result in lower quantities of physical capital and, as a result, may reduce the economy’s
productive capacity in the long term.14
Crowding Out Government Spending
Rising debt may also be of concern due to its associated interest payments. When the government
borrows money from the public, it must pay back that money with interest. The amount of interest
the government has to pay in a given fiscal year is a function of the size of the debt and the
interest rates on the debt. All else equal, an increase in the level of public debt (even absent an
increase in interest rates) results in an increase in interest payments that the government must
make each year, further increasing future deficits. Rising interest payments may therefore crowd
out government spending on other policy priorities. If Congress decides to lower future deficits so
as not to crowd out spending on particular policies, this would require spending cuts elsewhere or
higher taxes.
Growing Deficits and Debt in the Current
Macroeconomic Landscape
The economy today looks very different than it did even a few years ago. Deficits and growing
debt can affect the economy in the short term and the long term. However, the state of the
economy simultaneously contributes to the ways in which deficits and the debt are likely to affect
certain parts of the economy. In order to elucidate policy questions surrounding fiscal policy, it is
therefore helpful to first consider the current state of the budget and debt in the context of the
economy and recent economic trends.
Recent Trends in Deficits and Publicly Held Debt
For most of the past half-century, the federal government has run budget deficits and added to the
stock of publicly held debt (see Figure 1 and Figure 2 below). In relation to the size of the
economy, both deficits and debt have increased over time. The deficit-to-GDP ratio tends to
fluctuate around recessions, owing in part to fiscal policy changes based on the business cycle
and also to automatic stabilizers—cyclical fluctuations in revenue and spending that change
automatically, such as an increase in tax revenue when incomes rise during an expansion.15 The
deficit less these automatic stabilizers is known as the structural deficit.

13 Infrastructure is a part of the capital stock, and therefore increased public investment financed via deficit spending
can still lead to a higher capital stock overall and therefore increase the productive capacity of the economy.
14 Ball and Mankiw, What Do Budget Deficits Do?
15 For more details, see CRS In Focus IF11253, Introduction to U.S. Economy: Fiscal Policy, by Lida R. Weinstock.
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When considering the economic effects of deficits and debt, some of the most common metrics to
consider are the deficit-to-GDP ratio and the debt-to-GDP ratio. The nominal value of the budget
deficit or the stock of debt matters less in theory than their ratios to GDP do because, so long as
the economy is growing faster than the deficit or debt and interest rates are stable, the government
should not face steep tradeoffs to running budget deficits or have difficulty servicing the debt.
These ratios can be particularly useful when considering policy questions such as debt
sustainability (which is discussed in detail in the “Debt Sustainability” section at the end of this
report). For example, if the stock of debt is growing at 1% per year and GDP is growing at 2%
per year, then the debt is actually getting smaller relative to the size of the economy, and the
government’s ability to meet its obligations is higher despite the stock of debt rising. Additionally,
if the nominal growth rate in the economy is larger than the average interest rate paid on debt, the
government will devote smaller portions of its budget to paying interest on the debt over time.
In recent years, both the deficit-to-GDP and debt-to-GDP ratios have reached new highs. While
deficits were already relatively large prior to the pandemic, in response to COVID-19, significant
expansionary fiscal policy was put in place, resulting in the largest deficit-to-GDP ratio since
World War II.16 Even though fiscal stimulus programs enacted during the pandemic have mostly
expired, the deficit-to-GDP ratio remains large by historical standards, particularly when
compared to other economic expansions. The fact that the economy is likely near or at full
employment currently could make it more likely for some of the risks of expansionary fiscal
policy to occur. Furthermore, the Congressional Budget Office (CBO) forecasts that the debt-to-
GDP ratio will rise again in coming years under current policy. The current and projected trends
in deficit spending also mean that debt has grown and is expected to continue to grow at a
relatively rapid pace. According to CBO:
Historically, when unemployment has been low, deficits have been much smaller as a
percentage of GDP than the deficits in CBO’s current projections. From 2024 to 2033—a
period in which the average unemployment rate is projected to remain at or below 5.0
percent in each year—deficits in CBO’s baseline projections are never less than 5.5 percent
of GDP. From 1973 to 2022, the unemployment rate was at or below 5.0 percent in 12
years. Deficits in those 12 years (adjusted to exclude the effects of timing shifts) averaged
1.5 percent of GDP.17

16 Office of Management and Budget, President’s Budget Historical Tables, https://www.whitehouse.gov/omb/budget/
historical-tables/.
17 CBO, The Budget and Economic Outlook: 2023 to 2033, February 2023, https://www.cbo.gov/publication/58946.
CBO projections assume no policy changes and average economic conditions over the longer term. Therefore,
projections are not inherently more likely to be over- or underestimates. CBO publishes reports on the accuracy of its
projections, available at https://www.cbo.gov/topics/budget/accuracy-projections.
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Figure 1. Federal Deficit as a Percent of GDP
FY1965-FY2033

Source: Congressional Budget Office (CBO).
Notes: Gray bars denote recessions. A negative ratio indicates a budget deficit, and a positive ratio indicates a
budget surplus for a given fiscal year.
On the longer-term horizon, CBO forecasts that growing deficits under current policy will
contribute to a growing publicly held debt-to-GDP ratio that is expected to reach 181% in 2053,
leading to concerns about the sustainability of the debt (discussed in further detail in the
subsequent “Debt Sustainability” section).18

18 CBO, The 2023 Long-Term Budget Outlook, June 2023, https://www.cbo.gov/publication/59331.
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Figure 2. Publicly Held Debt-to-GDP Ratio
FY1965-FY2033

Source: CBO.
Note: Gray bars denote recessions.
Current Economic Landscape
The extent to which the economy is likely to experience negative effects from persistent and
increasing deficits and growing debt is dependent, in part, on certain underlying characteristics of
the economy. Prior to the pandemic, interest rates and inflation remained low despite persistent
deficit spending, which led some to believe that the risks of growing deficits and debt had
diminished.19 Now, the economic landscape is changed. Owing to a combination of factors,
including expansionary fiscal policy, inflation rose in the post-pandemic economy and remains
above target.20 This recent dynamic has potentially changed the relative magnitudes of the
tradeoffs of fiscal policy. This section discusses three aspects of the economy—inflation, interest
rates, and real GDP growth—how each has changed in recent years, and how this change relates
to the economics of fiscal policy.
High Inflation
Before inflation started rising in early 2021, it had largely remained below the Fed’s target since
the 2007-2009 financial crisis and recession. Low inflation allowed for accommodative monetary
policy and low interest rates. In general, low interest rates reduce many of the risks associated
with persistent deficit spending and a growing stock of debt—for example, crowding out private
investment and increasing the trade surplus—because those risks largely are driven by rising
interest rates. However, beginning in early 2021, inflation began rising, hitting highs not seen

19 For example, see CRS Report R45976, Deficit Financing, the Debt, and “Modern Monetary Theory”, by Grant A.
Driessen and Jane G. Gravelle.
20 For a more detailed discussion of the causes of inflation, see CRS Report R47273, Inflation in the U.S. Economy:
Causes and Policy Options, by Marc Labonte and Lida R. Weinstock.
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since the 1980s, which fundamentally changes how deficit spending is expected to affect the
economy.
Not only might high inflation increase the risks of deficit spending, but deficit spending that
brings the economy to or past full employment is itself a potential driver of inflation. One of the
reasons inflation is associated with an overheating economy is that when aggregate demand rises
(and in some cases outstrips aggregate supply), unemployment tends to fall. All else equal, this
would tend to be accompanied by an increase in wages and prices.
The Phillips Curve is a graphical representation of the relationship between unemployment and
inflation and can be used to illustrate how closely the two are related in a particular time period.
In the post-financial-crisis years, the inverse relationship between these two variables was
weaker, a phenomenon referred to as the flattening of the Phillips Curve (see relatively flat blue
trendline in Figure 3). As mentioned, inflation remained relatively low during the 11-year
expansion that preceded COVID-19, even as unemployment rates fell below 4% and the economy
arguably neared full employment late in the expansion. However, the slope of the Phillips Curve
has been relatively steep in recent years, with the low unemployment rate (similar to rates seen
immediately prior to the pandemic) associated with higher inflation (see steeper orange trendline
in Figure 3). These relationships suggest that deficit spending could be more likely to result in
temporary increases in inflation moving forward than was previously observed (although the
slope could change again). Some economists have posited other causes of inflation, but regardless
of whether low unemployment was the main cause of the rise in inflation, tighter fiscal policy
could still help reduce inflationary pressures going forward.
Figure 3. The Phillips Curve

Source: CRS representation using BLS Current Population Survey and Consumer Price Index data.
Notes: This figure is not a time series but a scatterplot that maps the relationship between two variables—
inflation and unemployment—with each point representing the inflation rate and unemployment rate in a
particular month. The blue points represent the combinations of inflation and unemployment in each month
from January 2010 to December 2020. The orange points represent the same for the period January 2021 to
August 2023.
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Inflation and Debt
Inflation reduces the real value (meaning the value in inflation-adjusted terms) of existing debt.
Typically, higher inflation is seen as advantageous to borrowers because it lets the debtor pay
back existing debt with money that is worth less than when it was initially borrowed. This is true
of government debt as well. In this way, the high inflation of the past few years has reduced the
burden of paying back pre-existing debt. However, the effects of inflation on new debt that has
been issued in the past few years differ from the effects on pre-existing debt.
The effect inflation has on the cost of newly issued debt depends on its rate relative to interest
rates. Inflation can reduce real interest rates (meaning nominal interest rates minus inflation,
which represent the inflation-adjusted cost of borrowing) if nominal interest rates do not rise as
much as inflation does. (Further discussion on interest rates and their effects on debt burden can
be found in the next section, “Rising Interest Rates.”) However, nominal rate increases in the past
year have been large enough to overtake the rise in inflation (as shown in Figure 4). Thus, in real
terms, the cost of servicing new debt has increased.
Figure 4. Real Interest Rates
January 2010 to October 2023

Source: Federal Reserve Bank of Cleveland, “Inflation Expectations,” https://www.clevelandfed.org/indicators-
and-data/inflation-expectations.
Higher inflation could bring down the debt-to-GDP ratio under certain conditions (e.g., inflation
sufficiently drives the growth in nominal GDP such that newly issued debt does not match or
exceed GDP growth). However, this effect would generally be offset when interest rates are rising
and deficit spending continues, as has been the case recently, because as existing lower-rate debt
matures, the government pays it off but issues debt at the new higher rates. Additionally,
persistently high inflation can result in lower GDP growth, further offsetting the beneficial effects
of lowered borrowing costs on the debt-to-GDP ratio.
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Research and past experience generally support the view that inflation does not tend to provide
any longer-term benefits in terms of reducing debt burden.21 In theory, inflation could play a
larger role in reducing debt burdens if the Fed did not respond to inflation with rate hikes.
However, inflation introduces many distortions to economic activity separate from the debt and
can become entrenched if not adequately responded to.22 As such, economists tend to agree that
achieving low and stable inflation is vital for overall economic health.
Rising Interest Rates
Despite periods of significant budget deficits, both long- and short-term interest rates trended
downward beginning in the mid-1980s and were consistently very low from the financial crisis in
2008 until 2022. These low rates were due in part to accommodative monetary policy and
persistently low inflation that kept rates anchored despite any upward pressure from deficit
spending. However, interest rates across the economy have been rising since 2022, spurred, in
large part, by the Fed’s aggressive hikes in the federal funds rate target range as it has aimed to
lower inflation.23 Rising deficits themselves are also likely playing a role in rising rates, as
described in the “Rising Interest Rate Risk” section above. As a result of both forces, interest
rates are the highest they have been since before the financial crisis and recession of 2007-2009.
As the Fed slows and potentially ends its rate hikes, increasing deficits could continue to raise
rates further.24
Monetary Policy
The Fed has raised the federal funds rate over 5 percentage points since March 2022, which may have a range of
effects on the deficit-to-GDP and debt-to-GDP ratios. Higher interest rates directly increase interest payments on
newly issued debt, in turn increasing net interest outlays and potentially resulting in more borrowing to cover
those increased costs. Monetary policy tightening also generally works to lower demand in the economy, which
can affect GDP in the short term. Higher interest rates, all else equal, can decrease interest-sensitive spending and
net exports in the economy, which both work to lower GDP.25
Higher net interest outlays and lowered GDP would both result in rising deficit-to-GDP and debt-to-GDP ratios,
all else equal. Nonetheless, a looser monetary policy stance could also result in rising ratios if it allowed high
inflation to remain in the economy. Historically, situations in which the economy has experienced high inflation for
extended periods has also resulted in lagging growth, a situation known as stagflation. Depending on the stance of
fiscal policy, deficits and debt could rise faster than GDP in such a situation. Stagflation is also much harder to get
under control, which could ultimately result in a more severe monetary policy tightening and even higher interest
rates than the economy is currently experiencing.26

21 For example, see Penn Wharton Budget Model, “Can Higher Inflation Help Offset the Effects of Larger Government
Debt?,” October 21, 2021, https://budgetmodel.wharton.upenn.edu/issues/2021/10/21/can-inflation-offset-government-
debt; Christopher J. Neely, “Inflation and the Real Value of Debt: A Double-Edged Sword,” Federal Reserve Bank of
St. Louis, August 1, 2022, https://www.stlouisfed.org/on-the-economy/2022/aug/inflation-real-value-debt-double-
edged-sword; and George Cole and Sara Grut, “DM Debt—How to Move Mountains,” Goldman Sachs, September 11,
2023, https://publishing.gs.com/content/research/en/reports/2023/09/11/69271985-9bd9-4150-8f3e-
0e90cd9ad21b.html.
22 See CRS Report R47273, Inflation in the U.S. Economy: Causes and Policy Options, by Marc Labonte and Lida R.
Weinstock.
23 See CRS Insight IN11963, Where Is the U.S. Economy Headed: Soft Landing, Hard Landing, or Stagflation?, by
Marc Labonte and Lida R. Weinstock.
24 Greg Ip, “Rising Interest Rates Mean Deficits Finally Matter,” Wall Street Journal, October 5, 2023,
https://www.wsj.com/economy/central-banking/rising-interest-rates-mean-deficits-finally-matter-74249719.
25 See CRS In Focus IF11751, Introduction to U.S. Economy: Monetary Policy, by Marc Labonte.
26 See CRS In Focus IF12177, Back to the Future? Lessons from the “Great Inflation”, by Marc Labonte and Lida R.
Weinstock.
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Interest rates are generally expected to come down at some point as inflation falls. The Fed projects that the
appropriate monetary policy path wil result in a federal funds rate of 2.5% in the longer run—relatively low in
historical terms but higher than most of the period since the 2007-2009 financial crisis and recession.27 The Fed
does not determine other interest rates in the economy, but rates are affected by movements in the federal funds
rate (as well as changes in economic and financial markets), with shorter-term rates affected more so and longer-
term rates less so.28 A long-term federal funds rate higher than what it was for much of the 15 years up to 2022
would likely translate to higher interest rates in general and a higher average interest rate on the debt. Even if
rates do go down somewhat, so long as they remain elevated from the previous period of very low rates,
policymakers wil face a steeper tradeoff when employing expansionary fiscal policy.
The federal government must pay interest on its debt to avoid default, and therefore the interest
rate on any given debt instrument is important to how much money the government needs to
spend on servicing the debt. Thus, net interest outlays are a function of the size of the amount of
debt outstanding, the budget deficit (which determines how much new debt is issued), and interest
rates. Lower rates can, if they are sufficiently low, keep stable or reduce the government’s outlays
even if the stock of debt increases. This can be seen in Figure 5 during the expansion between the
recession of 2007-2009 and the pandemic, when interest payments and GDP were growing at
relatively similar rates despite the rising debt because of low interest rates. Conversely, higher
rates put upward pressure on interest outlays.
Given the increasing interest rates since the pandemic and the growing stock of debt, net interest
costs have also been increasing. CBO projects, that as a percentage of GDP, net interest outlays
will increase in coming decades, reaching 6.7% by 2053 under current policy.29 CBO projects that
under current policy and average economic conditions in the medium to long term, deficits will
account for roughly one-third of the projected rise in net interest outlays and that increased
interest rates will account for the other two-thirds over the 2023-2053 period.30 All else equal,
growing servicing costs may result in further increases in deficits, the crowding out of other
policy priorities, and a rising debt-to-GDP ratio.31

27 Federal Open Market Committee, Summary of Economic Projections, September 20, 2023,
https://www.federalreserve.gov/monetarypolicy/fomcprojtabl20230920.htm.
28 See CRS In Focus IF11751, Introduction to U.S. Economy: Monetary Policy, by Marc Labonte.
29 CBO, The 2023 Long-Term Budget Outlook.
30 CBO, The 2023 Long-Term Budget Outlook.
31 Some research has suggested that rising interest costs may have a disproportionately smaller impact on the debt-to-
GDP ratio than on the deficit-to-GDP ratio in the next decade owing to recent and projected nominal GDP growth that
keeps pace with or outpaces nominal interest rate growth. See Jan Hatzius et al., “Interest Expense: A Bigger Impact on
Deficits Than Debt,” Goldman Sachs, October 3, 2023, https://publishing.gs.com/content/research/en/reports/2023/10/
03/bb300860-1725-423b-a688-06f3198b6448.html.
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Figure 5. Net Interest as a Percentage of GDP
FY1962-FY2053

Source: CBO.
Note: Gray bars denote recessions.
Interest Rates and Investment
As discussed previously, one of the main risks arising from rising interest rates is decreasing
business investment. Business investment can affect the economy’s short-term and long-term
growth. In the short term, an increase in business investment directly increases the current level
of GDP, because physical capital is itself produced and sold. Business investment is one of the
more volatile components of GDP and tends to fluctuate significantly from quarter to quarter. In
the long term, a larger physical capital stock increases the economy’s overall productive capacity,
allowing more goods and services to be produced with the same level of labor and other
resources. Long-term economic growth generally depends on growth in the economy’s productive
capacity rather than swings in supply and demand.32
As measured by the annual percent change in quarterly real private domestic investment, the
investment rate began decelerating in the second quarter of 2022 and has been negative in the
fourth quarter of 2022 and first half of 2023.33 The investment rate may pick up again assuming
interest rates eventually come down from current levels. In the longer term, the investment will
be dependent on a number of factors, including interest rates and deficits. As previously
discussed, if long-term interest rates settle at a higher level and deficits grow, this could put
downward pressure on the investment rate, all else equal. A lower investment rate could lower
short-term and, in particular, long-term economic growth.

32 For more information on business investment and the economy, see CRS In Focus IF11020, Introduction to U.S.
Economy: Business Investment, by Lida R. Weinstock.
33 Bureau of Economic Analysis, “National Income and Product Accounts,” https://www.bea.gov/products/national-
income-and-product-accounts.
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Investment and Saving
One of the long-term determinants of business investment is the level of savings available to the economy. When
individuals deposit their savings with financial institutions, those funds are then available to be loaned out to
businesses to invest. Because of the global nature of the U.S. economy, firms in the United States have access to
savings from within the United States and from abroad. Thus, interest rates in the United States are influenced by
the supply of global, in addition to national, savings. A higher supply of savings results in lower interest rates and
higher business investment, and a lower supply of savings results in higher interest rates and lower business
investment, all else equal.34
Stagnating Real GDP Growth
The U.S. economy has experienced slower real GDP growth in recent years than in previous
years. Since the 2007-2009 recession, annual real growth has exceeded 3% once, in 2015, out of
the 11 years of expansion prior to COVID-19. Prior to the 1980s, annual growth somewhat
regularly exceeded 5%. As shown in Figure 6 below, between 1950 and 1979, annual growth
averaged about 4%. This dropped to an average annual growth rate of 2.5% between 1980 and
2020 and is even lower when only the past decade is considered—annual average growth between
2010 and 2022 was down to about 2.1%, despite higher-than-average growth in 2021.35
Figure 6. Average Annual Real GDP Growth
1950-2022

Source: CRS calculations using Bureau of Economic Analysis data.
In the aftermath of the adverse economic effects of the pandemic, real GDP growth has been
especially uneven from quarter to quarter. As the economy recovered, real GDP growth
accelerated and was significantly above average in 2021. However, real GDP growth was
negative in the first half of 2022, owing in part to high inflation, and has since risen back to levels
similar to before the pandemic. It is challenging to predict the exact path of GDP in the coming
quarters, owing to uncertainty surrounding many factors, including how the economy will

34 For additional discussion of the supply of savings, see CRS In Focus IF10963, Introduction to U.S. Economy:
Personal Saving, by Lida R. Weinstock.
35 Bureau of Economic Analysis, “National Income and Product Accounts.”
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continue to react to tighter monetary policy and any future policy changes. Additionally,
economists expect certain demographic trends, notably slowing population growth, to continue to
adversely affect long-term growth.36 While the exact path of real GDP is uncertain, economists
generally expect growth to continue in its downward trend—both CBO and the Federal Open
Market Committee project longer-run real GDP growth rates of 1.8%.37
Policy Issues
Debt Sustainability
Debt sustainability is an issue with widespread and significant economic ramifications. One
narrower definition of debt sustainability is a country’s ability to service its debt without
defaulting. However, as discussed in the “Risks of Persistent Expansionary Fiscal Policy” section,
there can be negative economic consequences of having a large debt apart from such a fiscal
crisis, and arguably a country’s debt should be considered as unsustainable when this broader set
of outcomes occurs. But whatever definition is used, persistent fiscal stimulus resulting in an
ever-rising debt-to-GDP ratio—especially once it causes the perceived or real risk of the
government defaulting on that debt to rise—can lead to an unsustainable level of debt. As the
perceived risk of default begins to increase, investors will demand higher interest rates as
compensation. If rates become too high, it could cause a fiscal crisis in which the government is
unable to service its debts or is forced to print a significant amount of money to cover such costs,
which could result in rapidly increasing inflation.38
Fiscal crises caused by a government reaching an unsustainable debt level have occurred many
times in other countries, and perhaps some wisdom can be drawn from those foreign experiences.
However, the United States may prove a different case because of the wide international use of
the dollar. Foreign fiscal crises have often occurred during recessions as governments were forced
to borrow above their means and faced a choice between defaulting on loans and printing
currency to meet their obligations, which could then cause the currency to depreciate. This is less
likely to happen in the United States during a recession as investors tend to flock to the dollar as a
“safe haven” currency, causing it to appreciate. Further, the United States may be able to issue
more debt relative to largely similar counterparts, because U.S. debt is often seen as one of the
safest investments in the world and is widely used to underpin global financial transactions.39
Foreigners make up one of the largest categories of holders of U.S. debt,40 and some believe that
foreigners might be less confident in the dollar than Americans are, although this has not been
proven.
Recent trends, particularly that of rising interest rates, have brought the question of debt
sustainability back to the forefront of the policy debate surrounding fiscal policy. Already rising
interest costs are expected to continue rising in the short term, and the era of sustained low rates
appears to have ended. (As previously discussed in the “Rising Interest Rates” section, interest

36 Rainer Kotschy and David E. Bloom, Population Aging and Economic Growth: From Demographic Dividend to
Demographic Drag?, NBER, Working Paper no. 31585, August 2023, https://www.nber.org/papers/w31585.
37 Federal Open Market Committee, Summary of Economic Projections; and CBO, Budget and Economic Data,
https://www.cbo.gov/data/budget-economic-data.
38 CBO, Federal Debt and Risk of a Fiscal Crisis, July 27, 2010, p. 1, https://www.cbo.gov/sites/default/files/111th-
congress-2009-2010/reports/07-27_debt_fiscalcrisis_brief.pdf.
39 CBO, Federal Debt and Risk of a Fiscal Crisis, p. 5.
40 U.S. Department of the Treasury and Federal Reserve Board, “Major Foreign Holders of Treasury Securities,” March
15, 2021, https://ticdata.treasury.gov/Publish/mfh.txt.
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rates are expected to come down in future years but not reach lows seen in recent decades.) A
concern about this new interest rate environment is that it could accelerate the debt reaching a
“tipping point” in which economic growth is clearly and adversely affected or default becomes
imminent.
“Tipping Points”
There is not a general consensus about a tipping point at which debt becomes unsustainable. CBO
goes so far as to purposefully not define such a point: “[T]he debt-to-GDP ratio has no
identifiable tipping point because the risk of a crisis is influenced by other factors, including the
long-term budget outlook, near-term borrowing needs, and the health of the economy.”41
Nevertheless, there are those who have attempted to estimate such a tipping point. Prior to the
pandemic, there were a few estimates that garnered attention. In 2010, one study argued that
advanced countries with debt-to-GDP ratios above 90% had median growth rates about 1% lower
and average growth rates about 4% lower than their less indebted counterparts.42 Another group
of economists published further research in 2013 that countries with debt-to-GDP ratios above
80% and persistent trade deficits are vulnerable to rapid fiscal deterioration.43 The U.S. debt-to-
GDP ratio exceeded 90% beginning in 2020, and, as of yet, the United States does not appear to
have experienced any problems with sustainability, at least under definitions that require severe
outcomes.
The Federal Reserve Bank of Kansas City published further estimates in November 2020—after
the pandemic began but prior to increased inflation. The authors researched several different
scenarios given different assumptions about economic conditions and policy. In the baseline
scenario, the odds of default were found to begin increasing dramatically at a debt-to-GDP ratio
of 200% and become nearly certain around 275%.44 According to this model, the United States
may run a risk of being unable to meet its debt obligations in the future. CBO projects that the
debt-to-GDP ratio could reach 180.6% by 2053, below but nearing the 200% tipping point.45
An October 2023 analysis by the Penn Wharton Budget Model (PWBM) estimated that under
current conditions, the debt-to-GDP ratio would reach a tipping point at 200%.46 In the CBO and
PWBM baseline scenarios, the debt-to-GDP ratio will not reach 200% by 2050. (The ratios are
169% and 183% for CBO and PWBM, respectively.) However, in an alternative scenario in

41 CBO, Federal Debt: A Primer, March 2020, https://www.cbo.gov/publication/56309.
42 Carmen M. Reinhart and Kenneth S. Rogoff, “Growth in a Time of Debt,” American Economic Review, vol. 100
(May 2010), pp. 573-578. This research was largely put in doubt a few years later when academics from the University
of Massachusetts at Amherst discovered coding errors in Reinhart and Rogoff’s spreadsheets and unsound statistical
methodology. See Thomas Herndon, Michael Ash, and Robert Pollin, “Does High Public Debt Consistently Stifle
Economic Growth? A Critique of Reinhart and Rogoff,” University of Massachusetts Amherst Political Economy
Research Institute, Working Paper no. 322, April 15, 2013. Reinhart and Rogoff have admitted to the coding errors but
maintain the soundness of their conclusions. See Carmen M. Reinhart and Kenneth S. Rogoff, “Debt, Growth and the
Austerity Debate,” New York Times, April 25, 2013, https://www.nytimes.com/2013/04/26/opinion/debt-growth-and-
the-austerity-debate.html?hp&_r=0.
43 David Greenlaw et al., “Crunch Time: Fiscal Crises and the Role of Monetary Policy,” NBER, Working Paper no.
19297, August 2013.
44 Huixin Bi, Wenyi Shen, and Shu-Chun S. Yang, “U.S. Federal Debt Has Increased, but Appears Sustainable for
Now,” Federal Reserve Bank of Kansas City, November 16, 2020, https://www.kansascityfed.org/research/economic-
bulletin/us-federal-debt-increased-appears-sustainable/.
45 CBO, The 2023 Long-Term Budget Outlook.
46 PWBM, “When Does Federal Debt Reach Unsustainable Levels?,” October 6, 2023,
https://budgetmodel.wharton.upenn.edu/issues/2023/10/6/when-does-federal-debt-reach-unsustainable-levels.
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which interest rates are at least 50 basis points higher than baseline, the debt-to-GDP ratio will
surpass this tipping point by 2050.
Altogether, the research on tipping points—particularly the more recent research that was able to
account for more recent deficit spending trends—points to the United States being on an
ultimately unsustainable fiscal path, albeit with the potential tipping points and severe outcomes
occurring several decades in the future. Future economic trends remain uncertain, however, and
changes to the macroeconomy or fiscal policy stance could significantly alter spending and debt
outcomes. Ultimately, estimating such a number can be challenging, especially given the unique
position of the U.S. economy, as illustrated by the fact that post-pandemic estimates are generally
much larger than pre-pandemic ones.
Tradeoffs of Deficit Reduction
Given recent economic trends and the potentially increased risks of budget deficits given those
economic conditions, deficit reduction is at the forefront of many policy debates. In terms of
economic impacts, deficit reduction’s effects can be challenging to forecast given that the effects
in the short term and long term are likely to differ, potentially significantly so. The main
determinants of short-term growth and long-term growth are different, and while deficit reduction
can slow the economy in the short term, it can also spur the economy over the long term, resulting
in a balancing act for policymakers.
Deficit reduction would entail lowering government spending, raising taxes, or some combination
of both. In the short term, deficit reduction can help to lower inflation and interest rates but can
also lower aggregate demand. Similar to contractionary monetary policy, contractionary fiscal
policy can cause GDP to decrease and potentially result in recession depending on the timing and
scope of such reductions. A low inflation, low interest rate environment is more favorable for
questions of debt sustainability, but slower growth would be less favorable.
Short-term fluctuations in the economy can have very real consequences for economic actors. For
example, deficit reductions severe enough to result in significant decreases in aggregate demand
may affect labor markets, increasing unemployment and halting wage gains. A one-time deficit
reduction that is quickly reversed will not affect longer-term trends in deficits or debt. For deficit
reductions to be effective in altering the sustainability of debt, they must change both short-term
and long-term fiscal policy trends.
In the current context of low unemployment, higher-than-target inflation, rising interest rates, and
large deficits, there may be more room for deficit reductions without triggering a recession.
However, as discussed previously, the Fed has been tightening monetary policy, which may give
policymakers less leeway.
Is the U.S. Economy Headed for Recession?
Historically, periods of monetary policy tightening have more often than not resulted in recession. Given the
magnitude and speed with which the Fed increased interest rates since early 2022, economists have been
concerned to varying degrees about a “hard landing,” the outcome in which monetary policy becomes overly
restrictive and the economy slides into a recession. To this point, the economy has proved more robust than
expected, and inflation has come down considerably without any significant disturbance to the labor market.
Projections of a recession in the next 12 months have declined steadily over the course of the rate hikes. For
example, a quarterly survey of private sector economists by the Wall Street Journal showed that in September 2023
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economists believed the probability of a recession occurring within the next year was 48%, the first time the
probability was below 50% since the middle of 2022.47
A recession could result in opposing trends in terms of the effects on debt. On the one hand, a recession could
result in expansionary monetary policy and lowered interest rates, which, all else equal, could help lower net
interest payments. On the other hand, a recession could also result in expansionary fiscal policy, increased
structural deficit spending, and increased borrowing, which, all else equal, could result in increased net interest
payments and an increased debt-to-GDP ratio. In either scenario, GDP would likely dip temporarily, resulting in
upward pressure on the ratios. Over the longer term, a recession is less likely to impact deficits or the debt-to-
GDP ratio. The longer-term debt dynamics wil depend primarily on where interest rates settle and longer-term
trends in deficit spending.
Fiscal policy that lowers demand in the short term, can, in theory, improve longer-term economic
prospects if immediate deficit reductions are not just offset by larger deficit spending and
subsequently larger deficit-to-GDP ratios in the long term. This is because, in the long term,
economic growth is largely determined by the amount of physical and human capital and the rate
of technological change in the economy. The stock of physical capital is, in turn, largely
dependent on the rate of investment in the economy.48 Because sustained deficits can raise interest
rates, which disincentivize investment, deficit reduction can increase long-term growth.
Economists have tended to agree that, on the current fiscal policy path and absent policy changes,
the debt-to-GDP ratio will not stabilize or decrease over the long term.49 When, how, and by what
degree to reduce deficits, though, is highly debated. In general, when debating the appropriate
fiscal path and a sustainable level of debt, economists tend to focus on longer-term variables.
However, policy decisions are made with more certain information about the short term and with
short-term consequences clearer and more immediate. Finding a fiscal policy balance that allows
for both short-term and long-term growth—particularly long-term growth that keeps pace with (or
outpaces) debt growth—is likely to be challenging. Nonetheless, many economists agree that
deficit reductions of some degree may be necessary to ensure robust growth and avoid any issues
of debt sustainability and that the magnitude of any necessary reductions may increase the longer
current trends persist.50

47 Harriet Torry and Anthony DeBarros, “A Recession Is No Longer the Consensus,” Wall Street Journal, October 15,
2023, https://www.wsj.com/economy/a-recession-is-no-longer-the-consensus.
48 See CRS In Focus IF10408, Introduction to U.S. Economy: GDP and Economic Growth, by Mark P. Keightley and
Lida R. Weinstock.
49 See U.S. Government Accountability Office (GAO), The Nation’s Fiscal Health: Road Map Needed to Address
Projected Unsustainable Debt Levels, GAO-23-106201, May 8, 2023, https://www.gao.gov/products/gao-23-106201;
and U.S. Department of the Treasury, Executive Summary to the Fiscal Year 2022 Financial Report of U.S.
Government: An Unsustainable Fiscal Path, April 6, 2023, https://www.fiscal.treasury.gov/reports-statements/
financial-report/unsustainable-fiscal-path.html.
50 For example, see above Treasury and GAO reports or the following reports from CBO: The Economic Effects of
Waiting to Stabilize Federal Debt, April 28, 2022, https://www.cbo.gov/publication/57867; and Options for Reducing
the Deficit, March 6, 2023, https://www.cbo.gov/publication/58981.
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Author Information

Lida R. Weinstock

Analyst in Macroeconomic Policy

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