The Price America Will Pay for Higher Interest Rates

On September 16, the Fed raised its benchmark rate by 25 basis points—to 3.75–4%. The decision was unanimous. The committee explained the move as necessary to accelerate the return of inflation to the 2% target. For the market, the tightening may look like a signal of the regulator's determination to fight inflation. For the American budget, tightening means something else—more expensive refinanced debt at a time when the volume of maturities is particularly large. 

Debt has already become a separate budget problem

According to CBO (Congressional Budget Office) projections, net interest expenses of the federal budget in fiscal year 2026 will exceed $1 trillion—up from $970 billion the year before. Their share will reach approximately 3.3% of GDP. By 2036, the CBO expects this amount to grow to $2.1 trillion, or 4.6% of GDP:

This is fundamentally important: interest expenses are growing not only because of the Fed rate. The main factor is the volume of debt itself. In 2026, debt held by private investors continues to increase, while the budget deficit remains enormous. According to CBO estimates, for the first 11 months of fiscal 2026, the deficit totaled about $2 trillion. The result is a vicious cycle: the government has to borrow more and more, while the cost of servicing new and refinanced issues gradually rises. Interest on debt stops being a secondary budget line item and becomes one of its structural constraints.

Why the current increase is particularly sensitive

A rate hike doesn't mean that all American debt instantly becomes 25 basis points more expensive. Old ten-year and thirty-year bonds continue to be serviced at their previous coupons. The problem lies in debt that must be regularly refinanced.

Treasury bills (T-bills) with maturities up to one year are especially sensitive. It's the short end of the curve that's most closely tied to Fed monetary policy. When the Treasury issues a new bill after an old one matures, the rate on it already reflects the new financial conditions.

This is especially important given the heavy maturity schedule for 2026–2028. In the coming years, the Treasury will need to regularly replace enormous volumes of old debt with new issues. Therefore, even a small change in the average cost of borrowing eventually translates into tens of billions of dollars in additional expenses.

Three scenarios

Here it's important to separate arithmetic from forecast. The exact cost of the rate increase depends on what volume of debt will be refinanced, at what rates the Treasury will place it, and how the entire yield curve will change.

First scenario—the rate remains around 3.75–4% for a year

The direct effect will be relatively small compared to the entire federal debt. But as short-term issues mature and new deficit debt is placed, the higher cost of borrowing will gradually weigh on the budget.

Scenario Two: Further Rate Hikes

In this case, the pressure intensifies primarily on short-term issues. Each additional percentage point doesn't reprice the entire portfolio at once, but it does raise the cost of that portion of debt that regularly goes through auctions and refinancing. Over a horizon of several years, this could add tens, and eventually hundreds, of billions of dollars annually to interest expenses.

Scenario Three: The Fed Stops Hiking, but the Deficit Persists

This is the most important caveat. Even with rates unchanged, federal debt continues to grow. If the deficit remains around $2 trillion per year, interest expenses will increase in a few years simply because there will be a larger volume of obligations to service. This is precisely why the CBO, in its baseline projection, expects net interest expenses to grow from over $1 trillion in 2026 to $2.1 trillion in 2036—even without assuming rates rise indefinitely.

What This Means for the Budget

Interest expenses compete for money with other major line items in federal spending.

Rising debt service costs don't require Congress to pass separate legislation for new spending. They arise automatically when the Treasury has to borrow money at a higher price.

This is precisely why the problem differs from a typical budget dispute. The government can postpone building a road or change program parameters. But debt already issued must be serviced.

Meanwhile, demographic spending continues to rise. The CBO notes that in 2026, the increase in mandatory spending is largely tied to Social Security and Medicare.

The result is triple pressure: the debt itself is growing, its refinancing is becoming more expensive, and at the same time mandatory social spending is increasing.

The Fed's Paradox

This is the central paradox of the current cycle. The Fed is raising rates to cool demand and bring inflation back to 2%. At the same time, the federal budget continues to run a large deficit and accumulate more debt.

In this scenario, monetary and fiscal policy are working at cross purposes: the Fed is tightening financial conditions while the government continues to borrow substantial sums.

The problem is far more prosaic. High interest rates themselves become part of the fiscal problem. The more expensive refinancing becomes, the higher the interest expenses. The higher the interest expenses, the larger the deficit, all else being equal. And a larger deficit means new borrowing. The question is how long the U.S. budget can sustain high refinancing costs while running a persistent deficit.