Linkages among budget deficits, interest rates and the stock market for the US

What is it about?

This paper examines the dynamic linkages among the federal budget deficit, interest rates and the stock market for the United States from 1960 to 2006. The empirical strategy includes vector autoregression (VAR) and Granger causality analyses. The results suggest that budget deficits negatively impact upon stock returns, which implies a violation of the Ricardian Equivalence Proposition. Further analysis shows a higher sensitivity of stock returns to corporate taxes than to public spending. Finally, it is shown that although taxes are relevant for corporate profits in the short run, budget deficits are important for the stock market in the long run.

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Why is it important?

In general, sustained federal budget deficits negatively affect the equity market through increases in interest rates, which crowd out private investment and reduce asset values. Also, if interest rates rise, then the Federal Reserve may feel compelled to intervene and reverse such a rise so as to minimise the adverse effects of higher interest rates on the stock market.