Expected Future Budget Deficits and the U.S. Yield Curve

Abstract

Because of important demographic forces pertaining to impending social security and Medicare entitlement expenditures, very large budget deficits will occur in the next two decades barring significant federal legislation pertaining to these entitlements and/or taxes. The recent flatness in the yield curve notwithstanding, in this paper, we provide evidence that each one percentage point increase in the expected future deficit/GDP ratio increases the spread between ten-year Treasury bond yields and 90-day Treasury bills by 20-50 basis points. Larger expected deficits raise long-term rates more than short-term yield. To avoid crowding out of investment expenditures and the associated adverse effect on future living standards, it is imperative that Congress soon address the problem of looming deficits.