Treasury backflip: Deficit no impact on rates

A TREASURY paper has endorsed the federal government's stance that Australia's debt and deficits have no significant impact on interest rates either short-term or long-term.

In a stunning backflip from Treasury's earlier views, a new paper by two economists finds no causal link between movements in Australia's budget balance or government debt levels and the margin between Australian and US interest rates.

An earlier Treasury paper was quoted by the opposition during the election campaign to support its argument that the government's deficits were responsible for the Reserve Bank's six interest rate hikes in the past year.

But incongruously, the new paper concludes that the variables that really decide Australia's interest rates are all born in the USA.

It found not only are US Treasuries the global benchmark for interest rates, but the margin between them and Australian rates is determined primarily by shifts in US core inflation and the US current account deficit.

"All else equal, the results suggest that, in the long run, the real interest margin rises by around 3 basis points in response to a 1 percentage point (100 basis points) of GDP increase in the stock of Australian general government net debt", the paper reports.

The margin also rises by 10 basis points if the US government net debt falls by a percentage point something that, at this point, appears unlikely to happen any time soon.

"In the short run, Australian fiscal variables do not have a statistically significant impact on the interest margin," it concludes.

The paper, by Yong Hong Yan and Shane Brittle from Treasury's macroeconomic group, carries the usual disclaimer that its views are not necessarily those of Treasury. But they do match those of Treasury secretary Ken Henry, who has consistently played down any link between the budget deficits and rising interest rates.

Reserve Bank governor Glenn Stevens has also played down any link, arguing that it is the trends developing in the economy that influence setting short-term interest rates, and fiscal policy changes are rarely big enough to have an impact.

But the Treasury paper challenges a large body of work by other economists that find a strong link between fiscal policy and interest rates. A review published last year by the OECD suggested a strong, if highly variable, relationship, with long-term rates forecast to rise by between 10 and 60 basis points if the budget balance declines by 1 per cent of GDP.

Treasury Working Paper 2010-04: Reconsidering The Link Between Fiscal Policy And Interest Rates In Australia, Friday, 17 September 2010