The Recession

Deficit Spending & Interest Rates Could Derail Recovery

| by Heritage Foundation

By J.D. Foster

Long-term interest rates are rising rapidly, with the 10-year Treasury pushing against 4 percent for the first time since the summer of 2008 – before the financial markets collapse. The many influences on U.S. interest rates at the moment are all moving in the same direction – up.

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One influence is the growing concern that inflation could become a major problem in the near future, and this is building into the inflation expectation components of interest rates.

Another is simply the unwinding of the flight to safety following the initial debacle in financial markets. Interest rates across the maturity spectrum were driven artificially low as investors large and small sought to preserve the value of their principle. As concerns ease, interest rates will naturally rise to more normal levels.

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Yet another influence traces to the very recent rise in the price of oil. This increase has given fast money investors the first opportunity in many months to make serious profits, but first they have to sell some of their Treasury holdings, thus pushing interest rates higher.

The most dangerous driver of interest rates, however, is the U.S. budget deficit and the tremendous flows of debt coming out of the Treasury. This is simple economics – flooding the credit markets with U.S. debt means driving prices down and driving interest rates up. Bond market “vigilantes” – those major institutional buyers of government debt impervious to soaring rhetoric and political promises – have reawakened and want to see concrete steps toward getting the $2 trillion deficit under control.

Rising interest rates, for whatever reason, are a very real threat to the hoped-for economic recovery. The housing sector appears to be near stabilizing, but this progress can evaporate quickly if mortgage rates shoot up. There are only a couple actions government can take at this point to ease interest rate pressures. First, the President should make clear his intentions with respect to re-nominating Ben Bernanke as Chairman of the Federal Reserve Board. This issue is an unwelcome source of uncertainty hanging over financial markets.

Second, the President and the Congress must realize that bond vigilantes will not be swayed by new budget rules or other posturing. They want to see the economy strengthen while the deficit comes down now, and fast. The solution is to set aside all the new spending proposals and start cutting spending fast. Otherwise the economy’s few “green shoots”’ are likely to be killed off with a higher interest rate hard freeze.