Insight Line—February 11, 2008

President Bush’s recent revelation that his proposed fiscal 2009 budget of $3.1 trillion could potentially create a near-record fiscal deficit of $410 billion received little more than a shoulder shrug from the nation’s capital markets. In times past, such pronouncements elicited calls for fiscal responsibility for fear of rising interest rates. Is today’s lackluster response from investors callous indifference or a calculated understanding?

The easy answer is callous indifference, as the prospect for balanced budgets is more the exception than the rule. In other words, why worry over something beyond one’s control? But, perhaps the more informed answer rests with a growing understanding of exactly (so to speak) how investors should view rising or falling deficits.

Almost five years ago, research by the Federal Reserve’s (Fed) economic staff¹ proposed statistical support for how investors—and the Federal Reserve, for that matter—should quantify the affect of fiscal deficits on longer-dated U.S. Treasury securities, which act as a gauge of future interest rate expectations.

Granted, the effort was not without difficulties. You see, throughout most of the post-World War II period, the federal government operated with yearly budget shortfalls. Therefore, isolating and identifying the impact of federal budget deficits on interest rates is fraught with macroeconomic pitfalls. Nonetheless, in my opinion, the research did indeed develop a plausible working relationship between interest rates and federal budget deficits that investors seem to have embraced. That is, if the non-reaction to the federal budget of 2009 as well as to those of 2007 and 2008 is any indication.

At the risk of oversimplification, the relationship between interest rates and federal deficits can be summarized as follows: a one percentage-point increase in the federal deficit-to-gross domestic product (GDP) ratio potentially raises long-term interest rates by 25 basis points. Furthermore, converting the yearly fiscal deficit to ongoing levels of total indebtedness offers up one more working relationship: a one percentage-point increase in the outstanding federal debt-to-GDP ratio has the potential to raise long-term interest rates by four basis points.

Ordinarily, the Fed’s research receives little publicity, as it characteristically focuses on issues of importance to the nation’s central bankers rather than the investing public. However, this does not imply it goes unnoticed. In fact, as I see it, judging by the lack of alarm over record deficits in the financial media, investors appear to have embraced this particular analysis as a logical way to assess the headlines out of Washington.

¹Laubach, Thomas, “New Evidence on the Interest Rate Effects of Budget Deficits and Debt,” Board of Governors of the Federal Reserve System, May 2003. Available at www.federalreserve.gov/PUBS/FEDS/2003/200312/200312pap.pdf

This material has been prepared using sources of information generally believed to be reliable. No representation can be made as to its accuracy. The forecasts and opinions in this piece are not necessarily those of Van Kampen, and may not actually come to pass. Information in this report does not pertain to any Van Kampen product and is not a solicitation for any product.