Why So High?
Subject Federal Budget
Topic Taxes, Spending, and Deficits
Key Words Budget Deficit, Interest Rates, Budget Surplus, Inflation
News Story

Since last January, the Federal Reserve has cut its target federal funds rate by 4.75 percentage points to 1.75 percent. Long-term interest rates, which guide interest rates on mortgages and many consumer and business loans, have increased in recent months rather than following short-term rates. Some economists blame the fiscal policies of the Bush Administration as the reason for the rise in long-term rates. Others argue that rates have risen anticipating that the economy would rebound strongly this year and that the Fed would start increasing short-term rates.

Wall Street analysts and many economists believe that budget deficits have little influence on long-term interest rates. President Bush's tax cut was the primary reason that the Congressional Budget Office reduced the estimated budget surplus by $1.8 trillion form May to August, 2001. Decreased economic activity before September 11 shaved the estimated surplus by another $461 billion. According to John H. Cochrane, professor of economics at the University of Chicago, there is no evidence that budget deficits influence long-term rates. Even though the estimated surplus has shrunk, the amount of the deficit/surplus is too small to influence rates. According to Cochrane, the primary influence on long-term rates is inflation. It is the expectation of a recovery with greater probability of the Fed raising short-term rates that is responsible for the rise in long-term rates.

Other economists disagree. Peter Orszag, an economist at the Brookings Institution believes that long-term rates rise because of simple supply-demand logic. Before the tax cut and increased spending, the Treasury had planned to buy back hundreds of billions of dollars of its debt. These plans have been cancelled. To sell the extra debt to investors requires higher long-term interest rates. Mr. Orszag estimates that the reduced surplus adds one-half to one percentage point to long-term interest rates.

(Updated February 13, 2002)

1. What are the mechanisms by which the Federal Reserve influences short-term interest rates?
2. Is there a direct relationship between changes in short-term and long-term interest rates? Explain your answer.
3. What is the impact of higher long-term rates on consumers? On business firms? What do higher long-term rates mean for consumer spending? Economic recovery?
Source Daniel Altman, "Rates Remain High. Blame Bush Budget or Big Expectations?," The New York Times, January 9, 2002.

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