Interest rates cast cloud over deficit talks

Lawmakers are worried that uncertainty over a national default and concern over deficit spending could swell interest rates and cost the government over a trillion dollars in the next decade.

The wild card of interest rates has added a wrinkle in the debate over how much to slash spending and raise taxes to reduce the long-term national debt.

{mosads}“If interest rates go up 1 percent, that adds $1.3 trillion to the debt over the next 10 years,” said Sen. Kent Conrad (D-N.D.), chairman of the Senate Budget Committee. “Anybody that thinks somehow those concerned over the deficit and debt [are participating in] some kind of green-eyeshade exercise — no.”

Sen. Rob Portman (R-Ohio), who served as White House budget director under former President George W. Bush, shares Conrad’s worry.

“It’s a big concern. Think about it. A 1 percent increase in interest rates means more than $100 billion more in deficit spending,” Portman said. “The lack of confidence in the ability of Washington to deal with our historic deficits and debts [means] that investors could ask for a higher rate of return to invest in our country.”

Congressional Budget Office (CBO) Director Douglas Elmendorf sounded the alarm at a breakfast with reporters Tuesday. He warned that if interest rates on Treasury securities increase by only a tenth of a percentage point, it would increase the cost of borrowing by $130 billion over 10 years. His remarks were quickly noted on Capitol Hill.

Concerns over interest rates gained some momentum after Tuesday’s fairly steep sell-off in Treasuries, which pushed the yield on the 10-year Treasury note to 3.1 percent. Even though that was well below February’s 3.75 percent high mark, it served as an unpleasant reminder of potential volatility.

The interest rates on Treasury securities depend on several factors, but one of the most important is the confidence of investors that they’ll be paid back. The hardening lines in negotiations over raising the national debt limit and the projected long-term debt have undermined this confidence.

{mosads}This has spurred even the most partisan lawmakers to call for a quick resolution to the impasse over extending the nation’s borrowing authority. If Vice President Biden and congressional leaders fail to reach a deal by Aug. 2, they risk a default.

“The sooner and quicker we settle the debt ceiling, the better it will be,” said Sen. Charles Schumer (D-N.Y.).

Biden this week set a goal of early next month for reaching a deal to cut the deficit by $4 trillion over the next decade.

But negotiating positions have only become more entrenched in recent weeks.

Senate Republican Leader Mitch McConnell (Ky.) and other GOP leaders have declared tax increases off the table and insisted on cuts to Medicare.

Senate Majority Leader Harry Reid (D-Nev.), joined by Schumer at a press conference Tuesday, responded by vowing to oppose any deal that cuts Medicare benefits.

“We want to make our position on Medicare perfectly clear — no matter what we do in these debt-limit talks, we must preserve the program in its current form and we will not allow cuts to seniors’ benefits,” Schumer said.

Biden told reporters this week that negotiators have boiled things down to the most difficult issues: tax increases and entitlement reform.

“The really tough stuff that is left are the big-ticket items — and philosophically big-ticket items,” Biden said.

Financial analysts are split over the outlook for interest rates.

Axel Merk, president and chief investment officer of Merk Investments, based in Palo Alto, Calif., warns that interest rates could shoot up if Obama and Congress fail to rein in deficit spending.

“The concern is a very real one. U.S. government debt has been managed in recent years like an adjustable rate mortgage,” he said. “A lot of U.S. debt is at the short end of the yield curve.”

Merk said the bond market has cut the federal government slack because Congress has a track record of doing a “reasonable job” of keeping fiscal policy balanced. But he warned investors don’t have limitless patience.

“The margin for error is coming down,” he said.

Fitch Ratings announced last week that U.S. debt could receive a downgrade if Congress fails to raise the debt ceiling by Aug. 2.

Daniel Alpert, managing partner of Westwood Capital, based in New York City, said the markets are confident the standoff between President Obama and House Speaker John Boehner (R-Ohio) will end in a deal.

He says policymakers in Washington have overestimated the threat of inflation and rising interest rates.

“There is grave misconception on Capitol Hill on both sides of the aisle about the direction of interest rates and the susceptibility of the dollar to inflation,” he said.

Alpert believes the bigger problem is deflationary pressures because of the sluggish economy.