America’s Rising Debt Costs
The United States is paying increasingly more to borrow, while the government has fewer easy options to contain its rising debt-servicing costs. Long-term Treasury yields are near their highest levels in two decades, and several of the forces pushing them higher appear to be persistent rather than temporary.
Washington continues to issue enormous amounts of debt to finance deficits that show little sign of shrinking. Inflation has been slow to return to target, while a powerful wave of investment in artificial intelligence is helping keep the economy strong enough to prevent interest rates from falling sharply, even as sectors such as housing and automobiles struggle.
The result is a government interest bill approaching $1 trillion a year, against a national debt exceeding $40 trillion.
Limited Options
Policymakers have several ways to try to reduce borrowing costs. The Treasury can rely more heavily on short-term debt, while the Federal Reserve could, in more extreme circumstances, intervene directly in the long-term bond market.
But the further policymakers go, the greater the risk of creating new inflationary pressures. Efforts to suppress interest rates could therefore provide short-term relief while creating greater problems for bondholders and the broader economy.
Torsten Slok, chief economist at Apollo Global Management, estimates that roughly one dollar out of every five dollars the government collects in tax revenue is now being used to service the national debt. He expects that burden to continue increasing.
President Donald Trump has argued that economic growth or inflation could help reduce the debt burden. But if those forces are insufficient, the Treasury and Federal Reserve could face pressure to consider increasingly aggressive measures.
The Treasury is already relying more on short-term Treasury bills and has begun conducting small buybacks of older debt to improve market liquidity.
A New Operation Twist?
One possible escalation would be a revival of Operation Twist, a strategy first used in 1961. Under that approach, the government sells shorter-term debt while buying longer-term bonds, helping to push down long-term yields and flatten the yield curve.
A large-scale version of such a strategy would probably require the Federal Reserve's cooperation. Without the Fed's balance sheet, the Treasury has limited ability to directly lower long-term interest rates.
However, large-scale Federal Reserve purchases of government bonds can blur the line between monetary policy and government debt management. Fed Chairman Kevin Warsh has previously criticized the central bank's large holdings of Treasury and other securities and has called for closer coordination between the Treasury and the Federal Reserve.
The More Extreme Option: Yield Curve Control
If bond purchases failed to bring yields down sufficiently, policymakers could consider yield curve control.
Under this policy, the central bank commits to buying as much government debt as necessary to keep long-term interest rates below a predetermined ceiling. The Federal Reserve used a similar approach during and after World War II, keeping long-term Treasury yields capped at 2.5% from 1942 until the 1951 Treasury-Fed Accord.
Japan also operated a modern version of yield curve control from 2016 to 2024.
The advantage is clear: keeping borrowing costs artificially low would reduce the immediate financial pressure created by large government deficits. But the strategy carries a major risk.
If investors begin to believe that the government will ultimately repay its debts with heavily inflated dollars, confidence in Treasury securities could weaken. The central bank's purchases could then fuel inflation rather than simply suppress interest rates.
Two Very Different Paths
History suggests that the United States has two broad ways to reduce its debt burden.
The country has significantly reduced its debt-to-GDP ratio only twice since World War II. After the war, the ratio fell from roughly 106% of GDP in 1946 to about 23% by 1974. During that period, the 10-year Treasury yield rose from around 2.2% to 7.5%.
The second major decline occurred during the 1990s, when the debt-to-GDP ratio fell from about 48% to 32%. Unlike the postwar period, however, declining debt in the 1990s was accompanied by falling interest rates.
The difference was largely in how the debt burden was reduced.
After World War II, relatively high inflation and controlled borrowing costs allowed nominal economic growth to outpace Treasury yields, reducing the real burden of government debt without requiring severe fiscal restraint.
In the 1990s, by contrast, spending restraint and stronger government revenues played a much larger role.
The Inflationary Risk
Today's circumstances make a return to the 1990s model difficult. Mandatory spending represents a much larger share of the federal budget, while political support for major spending cuts or tax increases remains limited.
That leaves policymakers facing an increasingly uncomfortable choice: pursue painful fiscal adjustment, or tolerate policies that could keep inflation higher while suppressing borrowing costs.
As Veronique de Rugy of the Mercatus Center argues, ultimately the debt problem cannot be solved by the Federal Reserve alone. Congress would need to make a meaningful fiscal adjustment through spending restraint, higher revenues, or both.
For bondholders, the risks are therefore becoming increasingly asymmetric. The United States can reduce its debt burden through fiscal discipline and lower yields—or through a combination of financial repression, higher inflation and stronger nominal growth.
The latter path may make the debt look more manageable on paper, but it would likely come at the expense of investors holding long-term government bonds.
With borrowing costs already elevated and federal debt continuing to rise, policymakers are gradually running out of easy choices. The harder question is no longer whether the debt burden will create pressure, but which group will ultimately bear the cost: taxpayers, government spending programs, or bondholders.
Source: Reuters