Why Government Deficits Don't Affect Interest Rates

October budget data released Thursday shows a modest improvement in federal government finances, thanks mainly to the fact that spending in October of this year was about $90 billion less than it was in October of last year, when the frenetic bailouts and TARP legislation were launched.

Still, spending growth is likely to continue to outpace revenue growth, with the result that the federal debt will continue to rise in relation to the economy. As this next chart shows, there does not appear to be any solid relationship between debt outstanding and long-term Treasury yields. Indeed, the relationship appears for the most part to be counter intuitive, with bond yields moving inversely to the size of the debt.

Within reasonable limits (which we are still within), there is no reason for large deficits to impact interest rates, mainly because the latter are driven by inflation. Inflation, in turn, is ultimately controlled by the Fed, whose purchases this past year of $1 trillion or so of Treasuries and MBS threatens to push inflation higher in coming years.

Comments

[CautiousInv...:]

Without background information on prevailing monetary policy and rates of growth in money supply, the above is an incomplete argument and does not support the conclusions implied in the title of the article.

Nov 12 04:50 PM

[Ben Mauerbe...:]

I may stand to be corrected, however it seems to me this article could have been summarized in one sentence: Fiscal policy does not affect monetary policy.

Nov 12 05:51 PM

[Dave Wrixon:]

Yep, and he is so going to regret making that assertion!

He is also falling deeply into the trap that Central Banks set monetary policy in isolation from markets. Most often when spending gets totally out of control, they are just forced into playing catch up. Of course he could expand on his assertion that we are still within reasonable limits. I have been a bit down lately and would appreciate a good laugh.


On Nov 12 05:51 PM Ben Mauerberger wrote:

> I may stand to be corrected, however it seems to me this article
> could have been summarized in one sentence: Fiscal policy does not
> affect monetary policy.

Nov 12 06:01 PM

[Denis Gould:]

Budget deficits do affect interest rates. It is just that budget deficits affect other things more. And other things affect bond yields more.

Take the current situation. The budget defict is a result of a chronically weak economy. Hence low interest rates and bond yields.

Looking forward this crazy deficit means the US is going to need to run primary budget surpluses for a period spanning decades. The result is going to be economic stagnation and interest rates at zero. Suddenly bond yields of 3 or 4 are highly attractive and investors can borrow money at virtually zero rates and invest down the curve for a nice pick-up.

So while the deficit does keep yields higher than they would be with no deficit, if nothing else were different, the cause and consequences of the deficit are much more powerful drivers of yields.

Nov 12 07:25 PM

[TraderMark:]

I thought from the headline Dick Cheney had been secured as a certified Seeking Alpha writer.

Bummer.

Nov 12 08:08 PM

[Tollsforthee:]

In other news, Dewey Defeats Truman.

Nov 12 10:21 PM

[dingding:]

Bond yields are inverse to bond prices which are determined by supply and demand. Inflation expectations are only one factor that affects supply and demand. Right now there is a huge distortion in the supply and demand being caused by monetary policy and the state of the economy, as reflected in the steepness of the yield curve.

Nov 12 10:39 PM

[Valley Boy:]

I'm trying to follow the author's reasoning with an historic example.
I can remember that in the 1983-1986 time period inflation decreased to the extent it was called disinflation, interest rates crashed to a low level, the stock market shot up at a reasonable clip, the economy staged a healthy recovery---and yet, the federal government borrowed heavily to drastically increase the budget deficit with the military buildup and more social spending.
Maybe there is a bright economist who could explain to us why inflation did not increase in that period with the increased federal budget deficits. I wonder if it really was the bond yields which would explained the apparent discrepancy.

Nov 12 10:51 PM

[thotdoc:]

Mr. Gould-

You write like a rational man. I respect that. However, do you really believe that the US will run surplus for several decades?


On Nov 12 07:25 PM Denis Gould wrote:

> Budget deficits do affect interest rates. It is just that budget
> deficits affect other things more. And other things affect bond yields
> more.
>
> Take the current situation. The budget defict is a result of a chronically
> weak economy. Hence low interest rates and bond yields.
>
> Looking forward this crazy deficit means the US is going to need
> to run primary budget surpluses for a period spanning decades. The
> result is going to be economic stagnation and interest rates at zero.
> Suddenly bond yields of 3 or 4 are highly attractive and investors
> can borrow money at virtually zero rates and invest down the curve
> for a nice pick-up.
>
> So while the deficit does keep yields higher than they would be with
> no deficit, if nothing else were different, the cause and consequences
> of the deficit are much more powerful drivers of yields.

Nov 12 10:55 PM

[Moon Kil Woong:]

It does have some affect, however the US being the global trade currency buffers the effect. However, almost all economists agree the central bank/Federal Reserve rate setting, QE, and other policies is the main factor in debasement or firming of the dollar. Base money supply and abnormal interest rates matter more than any elected official's actions even though the Federal Reserve says otherwise.

Of course, our founding fathers would all cringe at the fact that money supply is in fact run by a bunch of bankers and not Congress as they intended. No wonder the public comes last in monetary matters. There will never be a discount window to the consumer, you will never save more than inflation with government bonds, and savers will never get a decent rate of return on their deposits so long as the Federal Reserve exists. These are the tenants of the Federal Reserve. Don't forget them.

Nov 13 12:45 AM

[ArizonaGlen:]

Antal Fekete has written alot of papers on this subject stating that deficits financed by quantitative easing provide for risk free bond speculation (because the speculators front run the Fed in the bond market since they know what interest rate target the Fed is trying to reach) which keeps rates low and actually exacerbates deflation, the exact opposite of the Feds goal. His papers are an extremely interesting read and give a good counterpoint to the prevailing wisdom of inflationary pressures going forward.

Nov 13 01:47 AM