March 7, 2011

Inflation Concerns Unlikely to Lead to Higher Interest Rates

Steven Horwitz

Senior Affiliated Scholar

Signs of inflation continue to rise across the globe, but the Federal Reserve is unlikely to raise interest rates in this tough economy, especially because doing so would increase the deficit. 

Raising rates increases the deficit, because interest on the debt is a large component of government expenditure.  People only buy bonds if they’re offered at an interest rate competitive with the market.  Higher interest rates mean that governments will only be able to sell bonds if they lower the price, which in turn means that they are paying more interest on those bonds, increasing the current deficit.

While raising rates to get rid of excessive reserves might be successful, mortgage and lending markets would take a hit, and the Fed is unlikely to raise the rates until they see a more significant sign of inflation in the United States.

If the Federal Reserve does decide to raise rates to get rid of reserves, it’ll be interesting to see how they will do it.  There’s no logical reason why they can’t mop up some of the excess reserves, there’s just a practical question of whether the plans are executable.