Appetite for treasuries, debt cycles, and fiscal inflation

Abstract

Despite accelerating debt levels, the real yield on U.S. Treasuries remains low due to investors’ desire for their extreme safety and liquidity services. The convenience premium on Treasuries allows fiscal policy to pursue profligate budget plans without imposing inflationary threats on a low-interest-rate monetary policy. Using a change-point vector autoregression model, I estimate the time-varying properties of U.S. inflation and fiscal stance that characterize long-term debt cycles. An archetypal debt cycle consists of alternating phases of persistent deficits and surpluses in tandem with alternating patterns of inflation and fiscal stance. I present a simple analytical model based on the fiscal theory of the price level where households have a preference for holding government bonds. When the real interest rate falls below the economy’s growth rate, permanent fiscal deficits can be sustained under passive monetary and active fiscal policy. I estimate an extended dynamic stochastic general equilibrium model and find strong negative correlations between fiscal policy and bond preference shocks across all subsamples. This suggests that flight-to-safety episodes may have systematically dampened fiscal inflation over the past two decades.