Oct 5 (Reuters) – The U.S. government is paying more to borrow and is running out of easy ways to control its borrowing costs. Long-term Treasury yields are near their highest level in two decades and the causes do not appear temporary. Washington is selling huge amounts of debt to cover deficits that are not reducing. Inflation has been slow to cool. And a boom in AI investment is keeping the economy strong enough that rates don’t fall, even though housing and autos are struggling. The result is an interest bill of about $1 trillion a year on a debt of more than $40 trillion. Washington has ways to fight back, from leaning more toward short-term borrowing to, in the extreme, having the Federal Reserve cap long-term yields. But the more policymakers draw on that toolbox, the greater the risk of stoking inflation, which could mean more pain for bondholders. For every $5 the government receives in tax revenue, a dollar is spent servicing the national debt, said Torsten Slok, chief economist at Apollo Global Management. “It’s a really high number and it will continue to rise.” US President Donald Trump said in an interview with Time magazine on September 28 that the debt can be paid off through growth or inflation, among other methods. But if that doesn’t work, the Treasury has other options that range from mild to drastic. It is already relying more on issuing short-term bills and making small buybacks of older debt to help boost market liquidity. In a much worse scenario, the next steps would require action from the Federal Reserve. It would be buying long-term bonds on a large scale, similar to Operation Twist in 1961. The other would be to put an absolute cap on long-term yields, something the United States has not done since World War II. The further down the list policymakers go, the more they can keep rates low, but they would risk worsening inflation. “We’re getting to the point where it’s pretty obvious that the government is getting uncomfortable with the level of rates,” Jeffrey Gundlach, CEO of DoubleLine Capital, said at a recent investment event. OPERATION TWISTBased on what has been attempted before, the first escalation would likely be a full reactivation of Operation Twist. That was the 1961 strategy of selling short-term debt and buying long-term bonds to flatten the yield curve. A significant turnaround would require help from the Federal Reserve, which can be held back unless there is a clear financial emergency. Without the Fed’s balance sheet, the Treasury “has limited resources to lower interest rates,” Slok said. However, Federal Reserve Chairman Kevin Warsh has criticized the Fed’s large holdings of Treasuries and other securities, arguing that large-scale bond purchases can “blur the line” between monetary policy and public debt management. bond and Treasury bond issues. YIELD CURVE CONTROL If spin-style purchases fall short, the next step would be explicit yield curve control. Here the central bank promises to buy unlimited public debt to keep long-term yields below a set ceiling. The Federal Reserve capped long-term Treasury bond yields at 2.5% to help finance World War II and the postwar recovery, from 1942 until the Treasury-Fed Agreement of 1951. The Bank of Japan pursued a version of this policy from 2016 to 2024. By keeping rates artificially low, yield curve control eases the political pain of deficits. But it only works as long as investors don’t fear being paid in inflated dollars. Once that confidence breaks down, purchases intended to keep rates low can instead fuel the inflation they were meant to hide. Ultimately, the only way to solve the debt problem is to cut spending, said Veronique de Rugy, a senior fellow at George Mason University’s Mercatus Center. “Congress needs to do fiscal tightening. In other words, austerity. The Fed can’t do it alone.” After the war, debt fell from about 106% of GDP in 1946 to 23% in 1974, while the 10-year yield rose from 2.2% to 7.5%. In the 1990s, debt fell from 48% to 32% of GDP and yields fell with it. What made the difference? After the war, limited borrowing costs and relatively high inflation boosted nominal growth relative to Treasury yields. That reduced the debt ratio without much fiscal discipline. In the 1990s, rates were slightly above growth, so restraining spending and raising incomes did the job. Today’s options follow those same two paths: austerity with diminishing returns, or financial repression and inflation, where returns rise even as the debt ratio improves. Mandatory spending now makes up a larger share of the budget than it did in the 1990s, and Congress doesn’t want tax increases or spending cuts. That’s why Higgins sees risks “leaning toward” an inflationary path that hurts bondholders. Report by Karen Brettell; Edited by Colin Barr and Edmund KlamannDisclaimer: The opinions expressed in this article are those of the author and may not reflect those of Kitco Metals Inc. The author has made every effort to ensure the accuracy of the information provided; however, neither Kitco Metals Inc. nor the author can guarantee such accuracy. This article is strictly for informational purposes only. It is not a request to carry out any exchange of commodities, securities or other financial instruments. 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