Deficit Announcements and Interest Rates

Abstract

Despite the fact that the most theoretical analyses (with the notable exception of the Ricardian equivalence approach) indicate that increased deficits cause interest rates to rise, the empirical evidence is at best inconclusive.1 In this note the relationship between interest rates and deficits is examined with the announcement effect methodology which has not previously been used in this context. We find evidence of a positive relationship between unanticipated announcements of the projected Federal government deficit and interest rates. In an efficient market, information about any determinant of interest rates should be quickly incorporated into observed rates. Thus, when information about the size of the deficits is released, a relatively quick impact on interest rates can be anticipated. More specifically, if an increase in the deficit is, in fact, associated with higher interest rates, then an unanticipated announcement of a larger deficit should lead to a response in financial markets, which increases interest rates. This paper provides evidence on the announcement effects of information on the deficit. The advantage of the announcement effect approach is that it precludes the necessity of specifying a structural model for interest rates.2 Projections of current and future Federal government deficits are made on a regular basis by both the Office of Managementand Budget (OMB) and the Congressional Budget Office (CBO), and receive wide attention in the financial press. These projections provide data that are related to the change in interest rate on government securities from the day before the announcement to the end of the announcement day. The macroeconomic hypothesis underlying this investigation is simply that an increase in the current or future deficit leads to an increase in yields on government securities in anticipation of higher levels of debt financing. In a rational expectations framework, an announcement of higher future deficits will lead to a current increase in interest rates in anticipation of future financing. Thus, the examination of announcement effects enables us to substantiate a relationship between interest rates and deficits without encountering the econometric problems of reduced form modeling. Section I begins with a description of the data. This is followed by a discussion of the methodology in Section II. Section III presents the empirical results. This is followed by our conclusions in Section IV.