A variety of factors affect interest rates – inflation is one of those factors. Inflation and interest rates are related. An increase in expected inflation will be reflected by an increase in interest rates, particularly medium and long-term interest rates. Investors want to have a greater return than the rate of expected inflation. As a result, increases in expected inflation will be reflected in the bond market. The chart below shows the Treasury yield curve on April 1, 2021 relative to one year ago. The Treasury yield curve shows the interest rates on Treasury bonds with different maturities – it shows relationship between short-term and long-term interest rates. Date 1 Mo 2 Mo 3 Mo 6 Mo 1 Yr 2 Yr 3 Yr 5 Yr 7 Yr 10 Yr 20 Yr 30 Yr 4/1/21 0.02 0.02 0.02 0.04 0.06 0.17 0.35 0.9 1.37 1.69 2.24 2.34 4/1/20 0.03 0.07 0.09 0.14 0.16 0.23 0.28 0.37 0.51 0.62 1.04 1.27 Interest rates have increased slightly across medium and long-term maturities. The interest rate on 5-year bonds increased 53 basis points, from 0.37% to 0.90%. The interest rate on 20-year bonds increased 120 basis points, from 1.04% to 2.24%. The bond market appears to reflect a slight expected increase in inflation. However, interest rates across all maturities are still at relatively low historical levels, with the 30-year bond rate at only 2.34%. The significant increase in Treasury debt by the Federal Reserve is currently not expected to significantly increase inflation. Another issue with increasing the federal deficit and total debt - the timing of the increase. Generally, during periods of economic duress, deficits will increase as the government needs to spend money to counteract the economic downturn. In periods of economic expansion, generally deficits should at least decrease as tax revenues increase. If you can’t reduce deficits in good economic periods, you never will. A significant side effect of the 2018 tax cuts was to increase the budget deficit in a period of economic growth. That set the stage for a significant increase in the budget deficit if anything went wrong with the economy – like it did. In 2020, the stimulus programs were going to be financed with debt rather than taxes. The objective was to increase consumer spending to help the economy recover. Raising any tax in 2020 was not a viable or appropriate economic policy option when consumers and businesses were struggling. The $2 trillion infrastructure plan is proposed to be financed with primarily corporate taxes. It is expected that economic growth will return in 2021. The increase in economic growth should provide an opportunity to reduce the budget deficit through increased tax revenues. The debt-to-GDP ratio is relatively high; although there is no specific benchmark as to what is too high, a high ratio indicates any adverse movements in inflation and interest rates could significantly increase borrowing costs. As a result, the proposal is to not increase the deficit and debt in a period of economic growth given the debt level is relatively high. The $2 trillion proposal in effect reallocates spending from primarily corporations to government infrastructure programs. Summary Economic optimism returns in 2021. The 2020 stock market predicted an economic rebound, and economic indicators show signs that is beginning to happen. Although uncertainty remains over the pandemic, significant progress has been achieved in fighting the virus. The pandemic was a medical and economic problem. Fixing the problem was crucial for an economic rebound. Economic growth is expected to return in 2021. Exactly how that growth occurs in 2021 and beyond could be significantly impacted by the passage (or not) of President Biden’s $2 trillion infrastructure plan. At the very least, 2021 promises to be another interesting year economically and politically.
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Center for Business and Economic Insight
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