Impact of federal budget deficits on the ex ante real interest rate yield on Moody’s Baa-rated long-term corporate bonds, 1960-2015

Abstract

PurposeTo investigate the impact of the federal budget deficit (expressed as a per cent of the Gross Domestic Product, GDP) in the US on the ex ante real interest rate yield on Moody’s Baa-rated corporate bonds and to provide evidence that is both contemporary and covers an extended time period, namely, 1960 through 2015.Design/methodology/approachThe analysis constructs a loanable funds model that involves a variety of financial and economic variables, with the ex ante real interest rate yield on Moody’s Baa-rated long-term corporate bonds as the dependent variable. The dependent variable is contemporaneous with the federal budget deficit and two other interest rate measures. Accordingly, instrumental variables are identified for each of these contemporaneous explanatory variables. The model also consists of four additional (lagged) explanatory variables. The model is then estimated using auto-regressive, i.e., AR(1), two-stage least squares.FindingsThe principal finding is that the ex ante real interest rate yield on Moody’s Baa rated corporate bonds is an increasing function of the federal budget deficit, expressed as a per cent of GDP. In particular, if the federal budget deficit were to rise by one per centage point, say from 3 to 4 per cent of GDP, the ex ante real interest rate would rise by 58 basis points.Research limitations/implicationsThere are other time-series techniques that could be applied to the topic, such as co-integration, although the AR(1) process is tailored for studying volatile series such as interest rates and stock prices.Practical/implicationsThe greater the US federal budget deficit, the greater the real cost of funds to firms. Hence, the high budget deficits of recent years have led to the crowding out of investment in new plant, new equipment, and new technology. These impacts lower economic growth and restrict prosperity in the US over time. Federal budget deficits must be substantially reduced so as to protect the US economy.Social/implicationsHigher budget deficits act to reduce investment in ew plant, new equipment and new technology. This in turn reduces job growth and real GDP growth and compromises the health of the economy.Originality/valueThis is the first study to focus on the impact of the federal budget deficit on the ex ante real long term cost of funds to firms in decades. Nearly all related studies fail to focus on this variable. Since, in theory, this variable (represented by the ex ante real yield on Moody’s Baa rated long term corporate bonds) is a key factor in corporate investment decisions, the empirical findings have potentially very significant implications for US firms and for the economy as a whole in view of the extraordinarily high budget deficits of recent years.