Interest Rates Are Going to Rise, But When? And by How Much?

President Bush's plan to increase federal gubmnt spending by $200b. for reconstruction and relief following hurricane Katrina will have to be funded somehow. He has explicitly ruled out tax increases.

Bush says the US gubmnt will have to cut spending elsewhere. But Mark Thoma has a detailed analysis of the possibilities, and they suggest that the maximum spending cuts will be only about $62b., leaving $138b. to be raised somehow.

In case you were wondering what Bush had in mind for cuts to offset spending on Katrina, one possibility is Cato's plan. Take a close look and see what you think. Then remember this only covers a third or less of the projected spending for Katrina (62 out of the 200 billion), and less than one sixth of the 400 billion dollar overall deficit projected by Cato.

Suppose the remaining $138b. won't be raised via taxes or via spending cuts. That leaves only increasing deficits, which means a substantial increase in the demand for lendable funds.

There are three possible scenarios, all of which will lead to an increase in interest rates:

1. Increases in the demand for lendable funds, by themselves, will have an impact on interest rates, but it might not be large in a world market: the supply of lendable funds to US borrowers, especially the US gubmnt, could very easily be highly interest-elastic. But if this expected growth in US gubmnt debt creates jitters among foreign and domestic lenders, this increased demand for lendable funds could easily drive up interest rates, a la "crowding-out" arguments.
2. What if the Fed monetizes this debt, buying up huge Treasury offerings and thus increasing the money supply? The resulting increase in aggregate demand would increase the rate of inflation, the expected rate of inflation, and, eventually, nominal interest rates (via the Fisher Equation).
3. Suppose, instead, the Fed fears that the increasing deficits will increase aggregate demand and exert inflationary pressure on the economy? The result might be immediate policies to force interest rates upward. [reg. req'd]:
   "But that extra stimulus, coming as the economy is expanding strongly and unemployment is low, also will fan inflationary pressures, analysts said.
   
   "That gives the Fed one more reason to move up its benchmark short-term interest rate Tuesday, and possibly to raise it higher than it otherwise would next year to make sure inflation stays under control."

Combine any one of these scenarios with the recent data indicating that unemployment rates have been low in the US, and it seems very highly probably that interest rates will be rising soon. And the rise could be substantial, though for the immediate future, William Polley expects it to be modest.

Everyone who thinks a big chunk of the increase in federal gubmnt debt will not be monetized, raise your hands.

Just as I expected. I don't see any raised hands.
All the more reason to rebalance out of long-term assets, including bonds.