NCPA - National Center for Policy Analysis

Deficits and Interest Rates

January 15, 2003

With the re-emergence of federal budget deficits, the question of whether deficits cause interest rates to rise is again being debated. One school of thought contends they do not.

Here is a look at the evidence being presented:

  • During the late 1990s when the projected budget surplus was increasing steadily, the 10-year real interest rate was rising -- although modestly.
  • The turning point in the rate's upward climb came in early 2000 -- even though the Congressional Budget Office's forecast was for continued, even larger, surpluses.
  • Since early 2001, the surplus projections reversed course as the economy weakened and the stock market retreated.
  • But instead of increasing along with deficit forecasts, the real interest rate on 10-year government securities fell.

Kevin Kliesen, an economist at the Federal Reserve Bank of St. Louis, points our that the behavior of the real rate of interest often reflects the pace of economic activity.

As the economy continued to expand through the late 1990s, increased pressures on financial markets pushed real interest rates upward. Similarly, the slowdown in the economy and the restructuring of economic expectations is reflected in its recent decline.

Source: Rik Hafer, "The Deficit Debate," Wall Street Journal, January 14, 2003; based on Kevin L. Kliesen, "Die Another Day? Budget Deficits and Interest Rates," National Economic Trends, Federal Reserve Bank of St. Louis, December 2002.

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