The big recession risk that no one is talking about

President Joe Biden is cheering a record plunge in the federal budget deficit, but the numbers belie a troubling trend that could come back to haunt him: The cost of government debt is skyrocketing.

The Federal Reserve's relentless campaign to crank up interest rates to kill the worst inflation in four decades is also driving up debt costs. The U.S. in the latest fiscal year spent more on interest payments than it did on veterans' programs and food and nutrition services combined — $475 billion, a 35 percent increase. And the number is only expected to grow.

That could limit the government’s ability to respond if the economy tumbles into a recession, potentially throwing millions of Americans out of work, as many economists expect next year.

During recent downturns, Congress helped cushion the blow by flooding the economy with stimulus checks and other relief. But doing that now while inflation is raging — even if it were politically possible — would pile on even more debt and could rattle investors wary of policies that could stoke higher prices. That’s a lesson that outgoing British Prime Minister Liz Truss learned the hard way.

“Any more big additions to the deficit are really risky,” said Jason Furman, who served as chairman of the Council of Economic Advisers under President Barack Obama. “We saw the U.K. heavily punished for that, and so I think that would be quite problematic.”

As a practical matter, it means government spending, from big agenda items to possible support for struggling households, would need to be offset with tax increases or spending cuts, not more borrowing, a colossal hurdle even when the president’s party controls both chambers of Congress. The midterm elections, now just weeks away, could give Republicans control of one or both houses of Congress, presenting another big roadblock for Biden.

White House officials said they don’t see cause for concern or for a change in the president’s fiscal policy stance. They said they don't expect a recession, but if there is one, it would likely be mild.

“The president has had a very consistent fiscal principle of more than paying for his policies,” said one senior White House official. “I expect that to remain.”

But the official said the dramatic reduction in the deficit under Biden has given policymakers room to borrow if needed. The Treasury Department on Friday said federal deficits shrank by $1.4 trillion in fiscal 2022 as surging tax revenue and waning pandemic spending helped cut the budget gap in half.

"Congressional Republicans love to call Democrats 'big spenders,' and they always claim to be for less federal spending," Biden said in remarks in the Roosevelt Room. "But let’s look at the facts. The federal deficit went up every single year in the Trump administration, every single year he was president."

The senior White House official also argued that inflation-adjusted interest rates are still below levels seen during the 2000s and said it doesn’t make sense to overstate the impact of rising rates on the fiscal outlook.

A second administration official said net interest payments, while rising, are still expected to remain low as a share of economic output — a metric that economists have increasingly pointed to as an important measure of debt sustainability.

But the recent turmoil in the U.K. shows the risks and challenges for policymakers grappling with how to respond to simultaneously soaring prices, rising debt and flagging growth.

The mere announcement of a proposal to cut taxes on the wealthy sent U.K. markets reeling last month, forcing the central bank to intervene and eventually prompting Truss to step down.

While there are important differences between the U.S. and the U.K., the episode served as a reminder that the amount of room policymakers have to borrow is in many ways determined by what the government debt market will allow, said Daleep Singh, chief global economist at PGIM Fixed Income and a former deputy director of Biden’s National Economic Council.

A fiscal plan designed to boost the economy’s capacity to grow would likely be received well by bond market investors, Singh said. A plan to send stimulus checks to every household probably would not.

“The lesson of the U.K. is, markets are going to be much more vigilant about any fiscal plan in this environment, particularly for countries that have a large debt stock that are potentially going into an economic downturn and are seeing interest rates move substantially higher,” he said. “You have to be really careful.”

That means closer coordination with market participants will be essential to gauge their reaction before fiscal policies are unveiled, Singh said, lest officials risk a bad reaction from investors.

For policymakers, that will probably mean crafting policies that provide targeted relief for vulnerable households, such as enhanced jobless benefits, that won’t be seen as aggravating inflation pressures and making the Fed’s job harder, said Louise Sheiner, policy director for the Hutchins Center on Fiscal and Monetary Policy and a former Fed economist. One way to do that is to offset aid with tax increases, though Democrats have struggled to garner support for such measures within their own party.

“In this recession, where the whole idea is to bring demand down, there will be tension between stimulus and relief” spending, Sheiner said. “I personally hope that the worry about stimulating the economy doesn’t prevent relief.”

While debt has become more expensive, it’s not so high that the U.S. will have trouble borrowing more money any time soon, said Marc Goldwein, senior vice president at the Committee for a Responsible Federal Budget. The bigger problem facing policymakers is that deficit spending could add to inflation.

But high and rising debt, and the growing costs that come with it, could draw a backlash from lawmakers, making it more challenging to forge agreements around how to help cushion the economy.

Interest payments are taking up a bigger share of the federal budget, and are on track to exceed Medicaid spending within a few years and top spending on the military by the end of the decade, according to Congressional Budget Office projections.

“Inflation is the economic constraint, but this may be the political constraint,” Goldwein said.