Interest rate prognosis

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Higher interest rates are coming. Last week, financial markets got a bit of a jolt when they suddenly realized this. Some analysts now predict fairly substantial increases by year's end. To assess their impact, it is important to understand why rates are rising. The short-term effect may be to bolster growth.

Interest rates basically rise for two reasons. The first is that the demand for funds exceeds their supply. For example, on the demand side, growth in the economy may raise the return to capital, thus encouraging additional borrowing by businesses for investment. Or government deficits may crowd private borrowers out of the market

On the supply side, the Federal Reserve may restrict the money supply or foreigners may cease investing in dollar-denominated assets because of a falling dollar.

The second reason interest rates rise is expectations of inflation. This cause first was identified by the great economist Irving Fisher and often is called the Fisher effect. He observed that a 1 percent higher expected inflation rate tended also to raise interest rates by 1 percentage point. Lenders demand compensation because the future interest and principal they receive will not be worth as much as the money they lend, in terms of the goods and services it would purchase.

It is important for policymakers to understand the Fisher effect can cause rates to rise even when the budget is in balance or when private borrowing is falling. It is simply a function of inflationary expectations. And inflation is, in the long run, entirely a function of monetary policy. Prices for certain things may rise at any time. But the general price level can only rise for more than a brief period if the Federal Reserve pumps too much money into the economy.

The Federal Reserve has had a highly accommodative monetary policy for more than three years. This was justified by the Fed's previous tight money policy, which brought about the stock market crash and the following recession.

By restricting money and credit in the economy, the Fed pressured prices downward, creating deflation, the opposite of inflation. But now many analysts believe the Fed has more than made up for past deflation and is sowing the seeds of inflation.

The Fed has not made up its mind on the subject. Public statements by various Fed officials show many remain concerned about deflation. Also, some Fed officials are convinced inflation can only result when unemployment falls well below where it is today. However, all Fed officials recognize the time will come when it must begin tightening monetary policy. Some observers fear the Fed may wait too long in order to avoid influencing the election.

Right now, the signs are mixed. Prices for some things like gasoline are up a lot. But this can be explained by lower oil output in Saudi Arabia and elsewhere and by unusually strong demand in China, which increasingly appears to be in a bubble, with its economy growing at an unsustainable rate. On the other hand, rising productivity is allowing businesses to raise profits without increasing prices for most goods and services.

However, it takes considerable time for an inflationary monetary policy to affect the general price level -- generally about two years. Moreover, when it does begin to have an impact, it will not affect all prices equally. Some analysts argue that the Fed's easy money policy has been channeled mainly into housing prices up to now. One hears more and more talk about a bubble in the housing market like the one we saw in the stock market in the late 1990s.

But money is fungible and eventually spreads throughout the economy. In the early stages of inflation, it raises corporate profits because businesses can raise their prices faster than their costs rise, especially for labor. Thus it is not contradictory for the stock market to rise even as interest rates rise -- if the basic cause is an inflationary monetary policy. Furthermore, investment may not be impaired because companies will be able to raise capital in a rising stock market, rather than by borrowing in the bond market.

Although, in my view, the Fed's easy money policy and rising inflationary expectations are the primary cause of rising rates, there are those who say the federal budget deficit is the main culprit and that higher taxes are needed to bring down interest rates. They would do well to remember rates rose sharply after Bill Clinton's 1993 tax increase. In 1994 alone, a year when the budget deficit fell sharply, rates rose 2 full percentage points.

As in medicine, a proper diagnosis for the economy is essential before implementing a cure.

Bruce Bartlett is senior fellow with the National Center for Policy Analysis and a nationally syndicated columnist.