Despite improving economic and budgetary news, there is rising pressure to do something about the budget deficit. I expect this pressure to grow rapidly over the next year. By early 2005, I believe such pressure will be irresistible. It's not too soon to start thinking about where this could lead.
The main reason why I see pressure building for a budget deal is that interest rates are going to rise sharply over the coming year. Following are some reasons:
-- Economic growth is accelerating. Many economists are now expecting 4 percent to 5 percent growth over the next year. This by itself will raise interest rates because it means that the rate of return to capital will be rising. If a firm can make more on a new investment, it will not mind paying more to borrow to capitalize on this opportunity. Thus increased business borrowing will raise rates.
-- Inflation is likely to re-emerge. For the last several years, deflation or falling prices have been the economy's biggest problem. In response, the Federal Reserve has increased the money supply and added a lot of liquidity to the banking system. I believe that this has finally reversed the deflation problem. But inflation raises long-term interest rates by adding an inflation premium to rates.
-- The dollar is likely to fall. The Bush administration seems convinced that forcing other countries, especially China and Japan, to raise their currencies is the key to reducing manufactured imports and raising exports. This is part of its electoral strategy for appealing to blue-collar workers. But raising foreign currencies is just another way of saying that the dollar will fall. While this may improve the trade balance, it will also reduce the willingness of foreigners to invest here. Reduced foreign capital inflows will raise interest rates.
-- Finally, the Fed will eventually see that inflation and a falling dollar require a tightening of monetary policy. This will raise short-term rates.
These are the most important reasons why interest rates will rise. But politicians and the media are likely to focus on only one thing: the federal budget deficit. Even though serious economic research shows little impact by deficits on interest rates, all of the rise in rates will be blamed on the deficit and only the deficit. This will be hyped in the liberal media ceaselessly in order to hurt Republicans and aid the prospects of whatever Democrat gains the presidential nomination.
Bruce Bartlett is a former senior fellow with the National Center for Policy Analysis of Dallas, Texas. Bartlett is a prolific author, having published over 900 articles in national publications, and prominent magazines and published four books, including Reaganomics: Supply-Side Economics in Action.
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