Janet Yellen warns higher rate outlook will make it harder to keep deficits and debt spending under control

“We have raised the interest rate forecast,” Yellen noted Friday in an interview with Bloomberg News. “It makes a difference. This makes it somewhat more challenging to keep deficits and interest expenses under control.”

Yellen was referring to the Biden administration’s budget proposals, which she said ensure the country stays on a sustainable fiscal trajectory. She reiterated her emphasis on the metric of inflation-adjusted interest payments compared to GDP. That ratio rose last year, but the White House sees it stabilizing at about 1.3% over the next decade.

“I don’t have a hard and fast rule, but I wouldn’t like to see it go above 2%,” she said, in her most specific comments yet on that guidance. She previously said the administration’s projections generated “historically normal” debt costs.

In contrast, Goldman Sachs Group Inc. Economists see the ratio exceeding that tolerance zone – forecasting real net interest payments to reach 2.3% by 2034. That was in a new analysis published on Wednesday. Five years ago, the bank’s forecast was 1.5%.

Rising interest rates are a major reason why the outlook has worsened. The Federal Reserve aggressively raised rates starting in 2022 to fight inflation, making it more expensive for the government to service its debt.

In its latest annual budget proposal, the White House projected 10-year Treasury yields at 3.7% in the early 2030s — almost a full percentage point higher than the 2.8% seen in its three-year proposal years ago. Treasury yields, which closely track the Fed’s benchmark rate, have risen by about half a percentage point in these long-term forecasts.

“We have included many deficit-reduction measures in the budget to keep interest expenses at a level that we think is fiscally responsible,” Yellen said. She was speaking to Bloomberg News in Stresa, Italy, on the sidelines of a Group of Seven meeting of finance ministers and central bank governors.

“We will open a tax negotiation,” Yellen said, alluding to the looming legislative battle over the tax cuts passed in 2017 under former President Donald Trump, which will expire at the end of 2025.

While Trump has vowed to extend the cuts, President Joe Biden wants to preserve the reductions only for those making less than $400,000 a year. As for the proceeds from the tax cuts that aren’t being extended, Yellen said in the interview that “some of it probably should be used” for deficit reduction.

Yellen said it “will also be necessary” to pay for provisions that are extended through new revenue. One way to help finance is implementing the global minimum corporate tax agreement, she said. “You have to do more than that, but it’s a payment.” On Saturday, she said the US is not ready to sign the final version of the deal.

Biden’s budget, released in March, also includes tax increases on capital gains and on households worth at least $100 million, among a host of revenue-raising proposals Republicans oppose.

Furman’s suspicions

Yellen noted that, “if we were to go back to the world of zero interest and assuming that was a sustainable long-term situation,” the path to net federal interest costs would be lower.

Her views on where borrowing costs will settle over time appear to have changed. Last October, she said it was “entirely possible that we will see longer-term yields come down” as many of the underlying trends that had depressed them in the past were “still there”.

While many observers focus on the overall debt-to-GDP ratio, Jason Furman and Lawrence Summers of Harvard University argued in a 2020 paper that policymakers should instead look to keep real net interest from rising above 2% of GDP. Summers, a former Treasury secretary, is a paid contributor to Bloomberg TV.

Furman, former White House chief economist in the Obama administration, said last year that the 2% guideline is not sacrosanct.

“It’s based on looking at experience in other countries, historical experience in the United States, our gut instinct,” Furman said in an interview last May. “I’m not positive it’s right.”

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