This study has reconsidered the link between fiscal policy and interest rates in Australia. Building on the work of Comley et al. (2002), we have examined the extent to which external factors drive movements in the interest margin between Australian and US real 10-year government bond yields. Specifically, the model incorporates Australian fiscal variables (primary balance and general government net debt) and a number of macroeconomic variables (the current account balance, GDP growth rate and inflation) that are expected to affect movements in the interest margin. The external influence on the real interest margin was considered by incorporating the US counterparts of these variables.
A general error correction model that incorporates both short- and long-run dynamics was specified and applied for two measures of the margin spanning the period 1990 to 2009. All else equal, the results suggest that, in the long run, the real interest margin rises by around three basis points in response to a one percentage point of GDP increase in the stock of Australian general government net debt, and by around ten basis points in response to a one percentage point of GDP decrease in US government net debt. In the short run, however, Australian fiscal variables do not have a statistically significant impact on the interest margin. Importantly, the results indicate that a number of US economic variables, namely inflation and the current account, exert the most powerful influence on the real interest margin.
A.1 Results of Comley et al. (2002)
Comley et al. (2002) investigated the potential link between fiscal policy and the real interest margin for Australian and US 10-year government bond yields, , over the period 1985 Q1 to 2001 Q2. The following set of explanatory variables was included in order to capture both long-term fundamentals and short-term influences on the interest margin:
= structural budget balance (% of GDP);
= headline budget balance (% of GDP);
= net public foreign debt (% of GDP);
= real GDP growth; and
= current account balance (% of GDP).
This framework attempted to model a long-term equilibrium relationship where the level of the real interest margin is a function of the flow and stock effects of fiscal policy, controlling for the inflation rate, real GDP growth and public debt. Short-term changes in the real interest margin were hypothesised as a function of changes in the budget balance and stock of public debt controlling for changes in the same set of variables. Specifically, the real interest margin is expected to rise in response to a deterioration in the budget balance or a rise in the stock of public debt. The real interest margin is expected to be positively related to levels and changes in the inflation rate, and in the stock of public debt, but negatively related to levels and changes in GDP growth and the current account balance.
Table 3: Results of Comley et al. (2002)
|Coefficient||Implied long-run coefficient|
|Explanatory variables: short run|
|Explanatory variables: long run|
Note: 1985Q1 — 2001Q2. t-statistics in parentheses. The long-run coefficients are calculated by dividing the coefficients for the relevant variables by the coefficient on the error correction term (lagged value of the dependent variable).
Their results indicate that the real interest margin increases by around 20 basis points in response to a 1 per cent of GDP deterioration in the Australian headline budget balance in the short run. A one percentage point of GDP increase in the stock of Australian public debt was found to increase the long-run real interest margin by around 15 basis points.
For the other variables, a one percentage point of GDP increase in the Australian current account balance decreases the real interest margin by approximately 17 basis points in the long run, while an equivalent increase in the Australian inflation rate increases the margin by approximately 10 basis points. A one percentage point increase in the Australian real GDP growth rate decreases the long-run interest margin by approximately 31 basis points.
A.2 Data Definitions and sources
— Indexed 10-year AUS government bond yield — Indexed 10-year US government bond yield. Source: Ecowin.
— Indexed 10-year AUS government bond yield — (Nominal 10-year US government bond yield — 5-year US inflation expectations, University of Michigan survey). Source: Ecowin.
Q1-1996Q4), (1997Q1-2009Q4). Source: Ecowin.
— Australian primary budget balance, per cent of GDP. (Excludes net interest payments). Source: OECD economic outlook database (as of March 2010).
— US primary budget balance, per cent of GDP. (Excludes net interest payments). Source: OECD economic outlook database (as of March 2010).
— Australian general government net debt, per cent of GDP. Source: OECD Economic Outlook database (as of March 2010).
— US general government net debt, per cent of GDP. Source: OECD Economic Outlook database (as of March 2010).
— Australian inflation rate (average of the underlying measures and adjust for GST effects), through-the-year. Source: RBA Statistical Table G1.
— US inflation rate (16 per cent trimmed mean), through-the-year. Source: Federal Reserve Bank of Cleveland.
— Australian real GDP growth rate, through-the-year. Source: ABS 5206.0 Australian National Accounts: National Income, Expenditure and Product, Dec 2009.
— US real GDP growth rate, through-the-year. Source: Ecowin.
— Australian current account balance, per cent of GDP. Source: ABS. 5302.0. Balance of Payments and International Investment Position, Dec 2009.
— US current account balance, per cent of GDP. Source: Ecowin.
Chart 1: Real interest margin, indexed bond yields
Chart 2: Real interest margin, indexed bond yields and US inflation expectations
Chart 3: General government net debt
Chart 4: Primary budget balance
Chart 5: Current account balance
Chart 6: Inflation
Chart 7: Real GDP growth
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7 We note that the limited size of the sample implies some caution against putting undue emphasis on our point estimates.
8 The five year inflation expectations series is obtained from the University of Michigan’s Surveys of Consumers.
9 A third alternative would have been to calculate the real interest margin using nominal bond yields and inflation data. However, this alternative is less desirable given uncertainties about the relationship between inflation expectations and actual inflation. In addition, using this measure would make it difficult to distinguish between real and nominal impacts on the yield spread given that inflation is one of the explanatory variables.
10 The variables included in the table are statistically significant at a 5 per cent significance level.
11 However, we note the relatively small sample size makes it difficult to test for unit roots with high precision.