Abstract This paper revisits the relationship between federal debt and interest rates in the U.S. A common approach is to regress long-term forward interest rates on long-term projections of federal debt. We show that issues regarding nonstationarity have become more pronounced over the last 20 years, significantly biasing recent estimates. Estimating the model in first differences rather than in levels addresses these concerns. We find that a 1 percentage point increase in the debt-to-GDP ratio raises the 5-year-ahead, 5-year Treasury rate by about 3 basis points. Roughly half of the interest rate response is driven by a higher nominal term premium.

Basu and Bundick, 2017 showed an intertemporal preference volatility shock has meaningful effects on real activity in a New Keynesian model with Epstein and Zin, 1991 preferences. We show that when the distributional weights on current and future utility in the Epstein–Zin time aggregator do not sum to 1, there is an asymptote in the responses to such a shock with unit intertemporal elasticity of substitution. In the Basu–Bundick model, the intertemporal elasticity of substitution is set near unity and the preference shock only hits current utility, so the sum of the weights differs from 1. We show that when we restrict the weights to sum to 1, the asymptote disappears and preference volatility shocks no longer have large effects. We examine several different calibrations and preferences as potential resolutions with varying degrees of success.