Interest Rates and the Fiscal Outlook
A great debate is breaking out over concerns for our growing debt, and it is centered around interest rates on Treasury securities. A fear held by many, including CRFB, is that growing deficits will cause investors to demand a higher risk premium on Treasuries, causing interest rates to rise and hurting the overall economy as a result. Commentators on both sides of the debate have used interest rates as proof of investors' level of concern regarding the fiscal outlook.
Those who are less concerned say the proof is in the pudding: even with record deficits, both short-term and long-term rates have been relatively low, indicating that investors are not worried about default risk on U.S. debt or inflation risk. However, as Steve Randy Waldman pointed out, these low rates have been largely due to the Federal Reserve's historically low rates.
A better measure to use to gauge investor concerns is the yield curve. Waldman explains that long term rates are determined by adding the short term rate to a "term premium", which accounts for future interest rate and inflation risk (presumably default risk as well). The yield curve, which subtracts a short term Treasury rate from a longer term rate (normally 2 years/10 years and 3 months/30 years), shows this term premium and therefore accounts for investor concern for future inflation and possible default. The results are clear:
"Since the financial crisis began, the market determined part of the Treasury's cost of borrowing has steadily risen, except for a brief, sharp flight to safety around the fall of 2008. Investors have been demanding greater compensation for bearing interest rate and inflation risk, but that has been masked by the monetary-policy induced drop in short-term rates."
Richard Fisher, the President of the Federal Reserve Bank of Dallas, made a similar observation. Fisher stated the U.S. can't ignore the effect that growing federal deficits will have on Treasury yields. He noticed, similarly to Waldman, that "the markets...have bid up longer-term nominal rates, resulting in a yield curve that is historically steep."
It seems clear that investors are already concerned about the risk of inflation or even flat-out default as a result of huge federal deficits. The longer we wait to take action, the more interest rates will rise, which will further increase the cost of borrowing to the federal government. We must get our fiscal house in order to avoid being entangled in this destructive cycle.
Interest rates and the fiscal outlook
Don't forget the impact the rising interest rates will have on the deficit!
As the rates rise, the interest due by the government will rise creating even larger deficits. A 1/2% rise in interest rates on our current debt would add another 65 Billion to the national debt!
Therefore we are now in an interest rate-deficit spiral that will continue until either 1) we regain control of spending or 2) Its OVER, the economy will reach double digit interest rates and triple digit deficits! Imagine if interest rates hit 14% again, our deficit would increase by $650 Billion just because of interest on the debt. Housing would be history. You get the picture.
This is where we're headed. How long can we put off doing something about out of control spending (for the sake of anything)?
No, Not Clear at All
I wouldn’t say that it’s “clear” that investors are concerned about inflation or default “a result of huge federal deficits.” In fact, it’s not clear at all.
First, it’s an elementary error to confuse correlation with causation. Investors may in fact be concerned about inflation (or default, which I highly doubt), but the evidence does not support that this fear is caused by federal budget deficits. Investors may be concerned that China will allow its currency to appreciate and make imports more expensive in the U.S. Maybe it’s anticipation that commodity prices, like oil, will take off. Or, they could just be optimistic that a growing economy tends to bring with it inflation. Who knows?
Second, although yield spreads appear to be increasing with the budget deficit, it’s useful to take a look just how closely those increases are related to the deficits. I ran some basic statistical analyses of average annual 2-10 year yield spreads, federal deficits and debt, GDP, and inflation. I found that the correlation between deficit (as percent of GDP) and the 2-10 year yield spread is 0.48. In other words, about half the variation in the yield spread can be explained by changes in the budget deficit. However, I also found that correlation between the yield spread and the effective fed funds rate (averaged over the year) is -0.75, a number providing a much higher degree of explanation. The correlation between yield spread and inflation is -0.51, stronger than the relationship between budget deficits and yield spread.
My analyses is far from scientific, and I’m sure could be adjusted to get cleaner numbers, but my point is that it appears budget deficits are most likely not the primary cause for the change in yield spreads.
Caig Jennings | Director | Federal Fiscal Policy
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