NCPA - National Center for Policy Analysis

FED TIGHTENING CAN BE BULLISH

July 6, 2004

If interest rates rise in coming months, many will automatically assume that it is because of the federal budget deficit, says Bruce Bartlett. However, a new study shows that this is not a factor, despite conventional wisdom to the contrary.

In a paper for the National Bureau of Economic Research, former Federal Reserve economist Eric Engen (American Enterprise Institute) and R. Glenn Hubbard, a former chairman of the Council of Economic Advisers, carefully review all the empirical and theoretical evidence regarding the impact of deficits on interest rates. They find the effect to be far smaller than generally assumed.

Their conclusion: "Our empirical results suggest that an increase in federal government debt equivalent to one percent of (gross domestic product), all else equal, would be expected to increase the long-term real rate of interest by about three basis points."

This is a trivial amount, says Bartlett:

  • One basis point is equal to one one-hundredth of a percentage point--equivalent to raising the rate on 10-year Treasury bonds from 4.6 percent to 4.63 percent.
  • Just between Tuesday and Wednesday of last week, the yield on this bond fell from 4.69 percent to 4.59 percent because the Fed reduced inflationary expectations by tightening monetary policy.
  • In short, whatever impact deficits have on long-terms rates is overwhelmed by other factors that may operate in the opposite direction.

In the long run, the best way to keep mortgage rates low is by keeping inflation low. Deficits matter in this regard very little and Federal Reserve policy matters a lot. The Fed has taken the first important step toward strengthening the dollar by tightening monetary policy. It's a step somewhat overdue, but still a move in the right direction, says Bartlett.

Source: Bruce Bartlett, "Fed Tightening Can Be Bullish," National Center for Policy Analysis, July 5, 2004.

 

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