Study quantifies debt's causal effect on interest rates
A new Federal Reserve working paper uses a natural experiment to measure the causal effect of expected debt-financed fiscal stimulus on interest rates. It finds that a 1 percentage point increase in the US debt-to-GDP ratio raises the longer-run neutral rate by 1-2 basis points and the 10-year Treasury term premium by 2-3 basis points.
The Georgia runoff experiment
The paper exploits a unique natural experiment following the 2020 United States elections, specifically the Georgia Senate runoff elections.
The outcome, single-party control by the Democrats, prompted a sharp upward revision in expected fiscal deficits and Treasury issuance.
Researchers inferred a Treasury supply shock of approximately $450 billion, or 2.1 percent of GDP, from this event.
Analyzing changes in Treasury yields on the day of and after the January 5th runoff, the study found that a 1 percentage point increase in the expected US debt-to-GDP ratio leads to a 3-4 basis points rise in real 10-year Treasury yields.
This effect decomposes into a 1-2 basis point rise in the longer-run neutral rate (r*) and a 2-3 basis point increase in the 10-year Treasury term premium.
These findings are statistically significant and robust across both high- and low-frequency identification methods, including an intraday approach.
Term premiums bear the burden
The study's findings corroborate estimates from a common time-series approach, lending causal support to existing literature that higher expected debt levels raise yields and term premiums.
A key finding is that the effects of higher debt supply are concentrated in term premiums rather than in the longer-run neutral rate (r*).
This indicates that the imperfect substitutability of government debt is an important determinant of the yield curve's elasticity to debt supply.
For monetary policy, the results imply that central banks retain scope to influence financial markets and macroeconomic activity by altering public debt holdings through asset purchases, particularly when short-term interest rates are constrained by the effective lower bound.
This is relevant for balance sheet policies.
Debt's true cost revealed
This paper provides robust causal evidence on a long-debated question, establishing a clear link between debt and interest rates.
The finding that term premiums bear the brunt of higher debt supply offers a nuanced understanding of market dynamics, reinforcing central bank balance sheet tools.
Its strong validation against time-series data makes it a significant contribution to academic and policy discussions.