Do Markets Care Enough about Deficit to Raise Future Cost of Capital? Non-Linear Deficit-Interest Rate Relationship in the U.S. Economy

Abstract

This paper finds strong evidence of non-linear impact of long-horizon expected government deficits, measured by CBO projections, on expected future long-term interest rates for the US economy. The impact of a shock to expectations (“news shock”) in a regime where the expected deficit/GDP ratio is above 1.8% (the estimated threshold value) increases future nominal interest rates by 29-30 basis point, and future real rates by 12-18 basis points. When expected deficit/GDP ratio is below 1.8%, a surprise increase in expectations of deficit has no statistically significant impact on future interest rates.

Keywords: deficits, interest rates, threshold

JEL Classification: C22, C32, E43, E62