US Market: Borrowing costs surge as debt burden limits policy options

The US government is paying increasingly more to borrow as long-term Treasury yields hover near their highest levels in two decades, raising concerns that Washington has fewer easy options to contain borrowing costs, according to a Reuters report.

The pressure comes from several fronts. The US is issuing large amounts of debt to finance persistent fiscal deficits, while inflation has been slow to return to the Federal Reserve’s target. At the same time, an artificial intelligence investment boom is keeping economic growth relatively resilient, limiting the scope for interest rates to fall even as parts of the economy, including housing and autos, weaken.

According to Reuters, the US government's annual interest bill has climbed to about $1 trillion, with total federal debt exceeding $40 trillion. About one in every five dollars of tax revenue now goes to servicing the national debt. the national debt, underscoring the growing fiscal burden.


Also Read | US stocks: Nasdaq gains 1% at close as investors focus on earnings

Washington has several options to manage borrowing costs, including increasing its reliance on short-term Treasury bills and buying back older debt. But more aggressive measures could eventually require the Federal Reserve to intervene, creating a risk that efforts to suppress yields could fuel inflation.

Operation Twist could be an early option

One potential escalation would be a revival of the Federal Reserve's Operation Twist, a strategy first used in 1961 to flatten the yield curve by selling short-term debt and buying longer-term bonds.

A significant version of the strategy would likely require Fed support because the Treasury has limited capacity to influence long-term borrowing costs on its own, the report stated.

Also Read | Why is France at the centre of a bond market storm?

However, large-scale purchases of Treasury securities could blur the distinction between monetary policy and government debt management. Fed Chairman Kevin Warsh has previously criticized the central bank's large securities holdings and has advocated closer coordination between the Treasury and the Federal Reserve over balance-sheet and debt-issuance objectives.

The Treasury is already making modest efforts to improve liquidity in the government bond market through buybacks while relying more heavily on short-term debt issuance.

Yield curve control carries bigger risks

If measures similar to Operation Twist proved insufficient, policymakers could consider explicit yield curve control. Under such a policy, the central bank commits to buying enough government bonds to prevent yields from rising above a specified ceiling.

The Federal Reserve used yield caps during and after World War Two, holding long-term Treasury yields at 2.5% between 1942 and 1951. Japan also operated a form of yield curve control from 2016 to 2024.

Such a policy can reduce the immediate cost of government borrowing, but it carries significant inflation risks. If investors begin to believe the government is effectively financing its deficits through artificially low interest rates, confidence in the currency's value could weaken. That could push inflation higher and ultimately force bond yields up rather than down.

The report stated that economists see fiscal adjustment, including spending restraint, as the more durable solution to the debt problem, rather than relying solely on the Federal Reserve.

Two different paths for reducing debt

Historical experience suggests the US has two broad ways to reduce its debt burden relative to the economy: fiscal discipline or inflation and financial repression.

After World War Two, the US debt-to-GDP ratio fell from around 106% in 1946 to 23% by 1974. During that period, long-term Treasury yields rose from about 2.2% to 7.5%.

Relatively high inflation and capped borrowing costs helped nominal economic growth outpace debt-servicing costs.

The 1990s were different. The debt-to-GDP ratio declined from about 48% to 32%, while bond yields also fell. Spending restraint and stronger government revenues played a larger role in reducing the debt burden.

According to Reuters, the current situation could more closely resemble the postwar experience if Washington avoids significant spending cuts or tax increases. Mandatory spending now accounts for a larger share of the federal budget than it did in the 1990s, while political resistance to fiscal tightening remains strong.

That leaves policymakers facing an uncomfortable choice: pursue fiscal austerity and potentially lower borrowing costs, or tolerate higher inflation and use financial repression to reduce the real burden of government debt.

For Treasury investors, the second path could be particularly painful, as higher inflation would erode the real value of fixed-income returns even if the government's debt burden improves relative to the economy's size.

(Disclaimer: This article is based on inputs from agencies. These do not represent the views of The Economic Times)