U.S. Deficit Shrank Last Fiscal Year, but Is Poised to Widen as Economy Slows

Economists widely agree the deficit is set to widen in most years through 2032 due to rising spending on entitlement programs like Social Security and Medicare and interest costs on the debt. A slowing U.S. economy and the costs of war in Ukraine could push government spending even higher than currently projected, analysts say. The White House in August estimated the shortfall will rise to $1.6 trillion in 10 years, while the nonpartisan Congressional Budget Office in May projected a more than $2 trillion annual deficit in a decade.

That could be a problem because of shifts in the global financial landscape. For nearly two decades, the U.S. government has had substantial leeway to keep borrowing to fund budget deficits, because inflation and borrowing costs were low. Among other things, this enabled aggressive federal interventions during crises in 2008 and 2020.

This year, in contrast, the Federal Reserve has responded to high inflation by aggressively lifting interest rates. In recent weeks, markets have sent signals that investor tolerance for increased government borrowing is waning, which could push rates higher still. In the U.K., recently, investors in government gilt bonds pushed back on the Tory government’s plan for tax cuts to be paid for by borrowing. They sold bonds, pushing up their yields. In response, the government backed off its plan and Prime Minister

Liz Truss

said she would resign.

In the U.S., borrowing costs are rising, too, but not as chaotically as in the U.K. The yield on a 10-year U.S. Treasury note, a reflection of what it costs the government to borrow from the public in the long-term, has risen to more than 4% this month, the highest level since 2007. The move is notable because long-term government borrowing costs didn’t shift much during earlier Fed rate increase cycles in the 2000s and 2010s, as is happening now.

Investors weigh a range of factors when deciding how much yield to demand on bonds when buying government debt, including the outlook for inflation, Fed rate policies and the supply of additional debt hitting the market. For many years, because inflation was low, the Fed kept short-term rates low and demand for bonds was robust. The market’s tolerance for government debt to fund deficits looked boundless.

Lou Crandall,

a bond market analyst with Wrightson ICAP, a research and brokerage firm, sees a risk that new supply-and-demand calculations are developing in the market. Central banks are reducing their government bond portfolios. In addition, private banks’ assets haven’t grown in line with the supply of Treasury bonds issued by the government, limiting the banks’ capacity to buy more bonds as deficits rise. Private investors also are reluctant to make commitments because they are uncertain about how high inflation will go, he said. This adds up to higher interest rates and a heavier weight on government borrowing.

“At this point we have longer-term issues that are important, but it is not leading to a crisis of confidence like you are seeing in the U.K.,” Mr. Crandall said. “There is a recognition that due to a confluence of factors, the U.S. government is going to right now need higher rates to pull money in.”

The U.S. budget deficit for the new fiscal year is forecast to be 3.8% of gross domestic product, according to CBO. The agency projects the deficit will reach 6.1% of GDP in a decade.

The federal government spent $6.3 trillion in the 2022 fiscal year, down 8% from the prior year, Treasury said. That largely reflected reduced government spending on Covid-19 programs. Government revenue from taxes and other sources rose to $4.9 trillion last fiscal year, the highest annual level on record and up 21% from the year before. Rising wages for many workers and a strong stock market yielding capital gains were drivers of higher income-tax collection.

“Between the traditional imbalance between spending and revenue and increasing interest rates, which are going to be more of a factor going forward, the overall deficit is going to gradually creep up,” said Alec Phillips, chief political economist at Goldman Sachs.

About $9.8 trillion, or 40%, of the national debt will mature and need to be refinanced within the next two years, and could be subject to higher interest rates, according to the nonpartisan

Peter G. Peterson

Foundation, which advocates for deficit reduction. The government spent $718 billion on interest costs on the public debt in fiscal year 2022, up 28% from the previous year, Treasury data show.

Republicans campaigning ahead of next month’s midterm elections have argued Democrats’ spending agenda spurred higher inflation, which is running near the highest rate in four decades.

The Biden administration and Democrats have countered that their policies helped fuel a strong economic rebound as the pandemic receded, provided a financial buffer for families and enhanced the economy’s potential to grow. The White House also pointed to a narrower deficit in 2022 as a justification for its student-debt relief plans.

“I do see our debt as being on a responsible path,” Treasury Secretary

Janet Yellen

told reporters Friday. She estimated the inflation-adjusted cost of government borrowing, as a share of GDP, would rise from negative levels to around 1% in the years ahead.

Clashes on the budget could increase if Republicans gain control of the House or Senate after the midterm elections.

During his time in office, President Obama repeatedly clashed with Republican leaders over the government’s self-imposed constraint on borrowing known as a debt ceiling, which freezes borrowing when certain debt levels are reached. The battles often rattled markets, because a borrowing freeze would raise the risk that the Treasury might fail to pay off interest on debt.

Republicans have argued the debt limit creates a needed restraint on spending. Mr. Biden on Friday said he wouldn’t support eliminating the debt ceiling altogether.

Rep. French Hill (R., Ark.) said if Republicans retake both chambers of Congress, the White House would likely have to negotiate a deal to cap federal spending growth in exchange for agreeing to raise the borrowing limit. “The Biden administration will have to work with Congress on the next debt-ceiling extension and connect that with moving back towards a prepandemic set of budget priorities,” he said in an interview Friday.

A possible recession would likely further widen the budget deficit. That would likely mean higher government spending on programs known as stabilizers, such as unemployment benefits or food stamps, said

Nancy Vanden Houten,

lead economist at Oxford Economics. She forecasts a mild recession during the first half of next year.

“We’re not looking for sharp declines in revenues or steep increases in spending, but the risks are enhanced that revenues will be weaker and stabilizers might have to kick in, given our outlook,” Ms. Vanden Houten said.

—Nick Timiraos and Richard Rubin contributed to this article.

Write to Amara Omeokwe at amara.omeokwe@wsj.com and Jon Hilsenrath at jon.hilsenrath@wsj.com