The best indicators of inflationary pressure are not the money supply or the unemployment rate or the capacity utilization rate. They come directly from markets. These indicators are telling us that the Fed should have braked before now. As Dave Gitlitz of Trend Macrolytics notes, the price of gold--the best leading indicator of inflation--is up 50 percent from its lows and 20 percent above its long-run average, even though it is off recent highs. Given the lags, this suggests that we have not seen the worst of inflation despite the Fed's belated move to tighten.
Unfortunately, if interest rates rise in coming months, many will automatically assume that it is because of the federal budget deficit. However, a new study shows that this is not a factor, despite conventional wisdom to the contrary.
It is authored by former Federal Reserve economist Eric Engen, now of the American Enterprise Institute, and R. Glenn Hubbard, dean of Columbia University's business school and former chairman of the Council of Economic Advisers. In a paper for the prestigious National Bureau of Economic Research, they carefully review all the empirical and theoretical evidence regarding the impact of deficits on interest rates and find it 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. 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, in my opinion, but still a move in the right direction.
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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