New Evidence on the Interest Rate Effects of Budget Deficits and Debt

Abstract

Estimating the effects of government debt and deficits on Treasury yields is complicated by the need to isolate the effects of fiscal policy from other influences. To abstract from the effects of the business cycle, and associated monetary policy actions, on debt, deficits, and interest rates, this paper studies the relationship between long-horizon expected government debt and deficits, measured by CBO and OMB projections, and expected future long-term interest rates. The estimated effects of government debt and deficits on interest rates are statistically and economically significant: a one percentage point increase in the projected deficit-to-GDP ratio is estimated to raise long-term interest rates by roughly 25 basis points. Under plausible assumptions these estimates are shown to be consistent with predictions of the neoclassical growth model.

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