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Home > Publications > Central Banker > Summer 2004 > Budget Deficits and Interest Rates: What Is the Li...

Central Banker | Summer 2004

Budget Deficits and Interest Rates: What Is the Link?

The Office of Management and Budget in February released the president's projections for the federal budget, which included an estimated federal budget deficit of $521 billion for fiscal 2004. The return of substantial budget deficits in the United States has reignited the debate on how budget deficits influence the economy.

Deficits can be a source of inflation if they are accommodated by monetary policy-that is, if the Federal Reserve responds to higher deficits by increasing the growth of money. The Federal Reserve has two ways of responding to higher deficits:

  1. The central bank directly purchases the securities issued by the government to finance the deficits.
  2. The private sector purchases these same securities; then, the central bank attempts to limit any potential interest rate increases.

Under either scenario, deficits lead to greater money base growth, which can create inflationary pressure.

Warnings about the consequences of U.S. budget deficits, while not new, have shifted over time. During the 1970s, emphasis was on the inflationary consequences of deficits. For example, in 1975, Ronald Reagan stated that inflation "has one cause and one cause alone: government spending more than government takes in." By contrast, the concern voiced since the 1980s rests on the argument that deficits put upward pressure on interest rates.

This shift is apparent in the market's current expectation that the Federal Reserve will not accommodate deficits with money creation. Since 1982, U.S. inflation has been controlled despite several years of high deficits. Fiscal 1983's $208 billion deficit was approximately 6 percent of GDP; this year's estimated deficit represents 4.5 percent of GDP. This demonstrates that monetary policy is capable of keeping inflation low even in the face of large deficits.

Why might interest rates rise in response to deficit financing? When you rule out monetary accommodation of the deficit, the government needs to create an incentive for the private sector to buy more government bonds. If the private sector's purchase of government bonds does not increase one-for-one with the higher deficit, the government must borrow more money, which leaves less money for financing private projects, such as investment in residences or factory equipment. This is sometimes referred to as the "crowding-out" effect.

Higher interest rates also can reduce the private sector's demand for capital, thereby reducing the demand for commercial and retail borrowing. This underlies what Douglas Holtz-Eakin, the director of the Congressional Budget Office, has summarized as a "modestly negative" effect of long-term budget deficits.

Two recent studies have measured the influence of budget deficits on interest rates. The first of these studies, by Thomas Laubach, finds a "statistically and economically significant" relationship between higher deficit projections and future long-term interest rates. According to Laubach's estimates, when the projected deficit to GDP ratio increases by one percentage point, long-term interest rates increase by roughly 25 basis points. A more recent working paper, by Eric Engen and R. Glenn Hubbard, found that when government debt increased by 1 percent of GDP, interest rates would increase by about two basis points.

The Laubach study implies that moving to a balanced budget would tend to reduce interest rates by about one percentage point; however, the Engen and Hubbard study suggests that interest rates would only fall by roughly a tenth of that amount. While recent research confirms there is a significant relationship between budget deficits and interest rates, just how much deficits affect interest rates is still being debated.

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