Recent Evidence on the Impact of Government Budget Deficits on the Ex Ante Real Interest Rate Yield on Moody's Baa-Rated Corporate Bonds
Cebula, Richard J., Cuellar, Pablo, Journal of Economics and Finance
This study provides recent empirical evidence on the impact of the federal budget deficit on the ex ante real interest rate yield on Moody's Baa-rated corporate bonds. The study is couched within an open loanable funds model that includes the ex ante real short term real interest rate, the M1 money supply, net international capital inflows, and the unemployment rate. Using quarterly data for the period 1973.1-2007.4, two-stage least squares estimation reveals that the federal budget deficit, expressed as a percent of GDP, exercised a positive and statistically significant impact on the ex ante real interest rate yield on these corporate issues.
Keywords Ex Ante Real Interest Rate * Budget Deficits * Loanable Funds Model
JEL codes E62G12
In the US, there was a brief experience with federal government budget surpluses during the 1998-2001 period. However, given the 2001 recession, sluggish economic growth since 2001, and budgetary demands involving proposed further income tax cuts on the one hand and the "war on terrorism" in the aftermath of the terrorist attacks on the U.S. on September 11, 2001 on the other hand, the specter of federal government budget deficits, potentially huge ones, has raised its ugly head once again. As Alan Krueger (2003) observes, budget deficits have re-emerged as a major economic concern.
The impact of deficits on interest rates has been studied extensively (Al-Saji 1992, 1993; Barth et al. 1984, 1985, 1986; Cebula 2005; Cukierman and Meltzer 1983; Feldstein and Eckstein 1970; Findlay 1990; Hoelscher 1983, 1986; Holloway 1988; Johnson 1992; Ostrosky 1990; Saltz 1998; Swamy et al. 1990; Tanzi 1985; Zahid 1988). These studies typically are couched within IS-LM or loanable funds models or variants thereof. Many of these studies find that the government budget deficit acts to raise longer term rates of interest while not significantly affecting shorter term rates of interest. Since capital formation is presumably much more affected by long term than by short term rates, the inference has often been made that budget deficits may lead to "crowding out" (Carlson and Spencer 1975; Cebula 1985; Krueger 2003).
The interest rate/budget deficit literature has generally focused upon the yields on Treasury bills, Treasury notes, and Treasury bonds, although occasionally the yield on other bonds (such as Moody's Aaa-rated corporate bonds) has received attention. In recent years, however, the deficit impact on Moody's Baa-rated bond yields, especially the ex ante real interest rate yield, has received virtually no formal attention in this literature. Accordingly, the purpose of this study is to provide current evidence as to the effect of the U.S. federal budget deficit on the ex ante real interest rate yield on Moody's Baa-rated corporate bond issues. Arguably the focus on this ex ante real long term interest rate is especially justified because of its relevance to private-sector capital formation decisions.
Using seasonally adjusted quarterly data, the study investigates the period 1973.12007.4. We begin with 1973. 1 because this is approximately the time of the abandonment of the Bretton Woods agreement. Ending the study period with 2007.4 makes this study very current and hence very pertinent. Moreover, using 34 years of quarterly data provides a relatively longer term perspective on the impact of the budget deficit on the ex ante real Moody's Baa-rated corporate bond interest rate yield. Section 2 provides the framework for the empirical analysis, an open loanable funds model. Section 3 defines the variables in the empirical model and describes the data. Section 4 provides the empirical results, whereas an overview of the study findings is found in Section 5.
2 The basic framework
Variable EARSR is the ex ante real short term interest rate yield. The variable EARBaa is the ex ante real interest rate yield on the long term corporate bond, and UN is the unemployment rate. …