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There's nothing wrong with driving up rates a bit.


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Larry Kudlow

From Robert Rubin to Alan Greenspan to Paul O’Neill to George Bush, just about everyone in Washington is talking about an economic stimulus package that won’t drive up long-term interest rates. But there’s nothing wrong with driving up rates a bit. For recovery, higher rates are the real deal.

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Wednesday in New York, President Bush presented the general outline of a $75 billion tax-cut plan, and it will probably include a faster phase-in for the personal tax-rate reduction plan, with a business tax-cut piece that will probably include faster depreciation on equipment purchases and relief from the alternative minimum corporate tax. Responding to a question from the press, the president said, “But we’re mindful of the effect on long-term interest rates, and we think that number is the right number.”

Official Washington has the interest-rate story completely wrong. Growth-boosting tax-cuts should lead to higher rates. Here’s why.

In today’s non-inflationary environment, most interest-rate swings are driven by changes in the real interest-rate component of the market rate (the rest of the market rate is taken up by the inflation expectations premium). Think of real interest rates as the economic growth component of a Treasury bond. So real interest rates track closely with stock markets and the economy. So-called real interest rates reflect the economy-wide rate of return on capital investment. As real returns rise, and real economic growth advances, rising real interest rates drive Treasury market yields slightly higher. There’s nothing wrong with this. Rising real interest rates merely reflect a healthy economy.

This is much different from the 1970s and other periods where inflationary fears were the biggest swing factor for interest rates, sometimes driving them five or six percentage points higher. In those cases skyrocketing market rates were a tall barrier to growth, as higher inflation closed down credit sources and acted like a huge tax increase on the economy, stifling investment, output, and job creation. Today, however, deflationary price falls are a much greater problem than inflationary price hikes.

The difference between real interest rates and inflation expectations may seem like a technical matter, but it’s hugely important. Between 1995 and 2000, for example, Treasury rates pushed slightly higher, but the economy was growing at better than 4% with tame inflation. The stock market roared. The average yield on the ten-year bellwether Treasury bond was 6.05%.

Today, however, that same ten-year Treasury is yielding only 4.5%. At first blush, this looks like a good thing. However, it’s not so good as the low interest rate reflects a recessionary economy. Over the past eighteen months, as the economy has shifted from boom to bust, the ten-year note has dropped from 6.5% to 4.5%. What happened? Well, the economic slump has brought down investment returns and economic growth. So the real interest rate growth component of the ten-year Treasury has shrunk substantially.

Tracking real interest rates is made easier by the advent of a new market instrument, namely Treasury Inflation Protection Securities (TIPS). (Click here for full accompanying charts.) TIPS trade daily in the open market. In addition to their roughly 3% interest coupon, their principal is protected by a semi-annual government payment which is pegged to the consumer price index. This inflation allowance offsets any principal value erosion from the effects of rising prices. Consequently, the inflation-proof yield on TIPS is a proxy for the economy’s real interest rate.

It turns out that inflation-indexed TIPS are highly correlated with the stock market and the economy. Declining investment returns, sinking stocks, and falling economic growth are all captured in declining real TIPS yields. Ten-year TIPS, for example, have dropped to roughly 3% today from nearly 4.5% eighteen months ago. This is the biggest reason for the decline in the nominal — or market — rate on ten-year Treasuries. Counter to what Robert Rubin is telling us, government bond yields are falling even while recessionary budget deficits are reappearing.

Going back to Mr. Bush, his new tax-cut plan is presumably designed to foster higher investment returns, stronger economic growth, and more jobs. But, higher after-tax returns to capital, business, and labor would be reflected in rising real interest rates. So investors would sell their TIPS and go back to buying stocks. Consequently, TIPS rates will rise. And that means the market rate on ten-year Treasuries will rise roughly in sync with the rising real interest-rate component.

If next year’s economy responds to tax-cuts and easier money with a 3.5% growth, it is likely that the ten-year Treasury rate will move up to perhaps 5% or 5.5%, or nearly a percentage point above today’s rate. This would be a good thing, not a bad thing.

So now we’re in the position of arguing that a mild increase in both real and nominal Treasury yields is something to be desired, not shunned. If Washington policymakers do their job, then raising after-tax investment returns and promoting stronger real economic growth will generate a completely different outcome than the one prescribed by Robert Rubin.

Whether Mr. Rubin understands real interest rates and TIPS securities is unknowable. Ironically, the real interest rate TIPS were launched during Mr. Rubin’s tenure as Treasury Secretary. So, if he goes back and re-reads some old memos from his former government agency, he will realize that the best thing for America would be a real interest rate-raising economic growth policy that helps win the war against terrorism abroad by promoting economic recovery at home.

On the other hand, if we pursue Mr. Rubin’s arguments to the extreme, we’re left with a Japanese-style interest-rate structure. Long-term government bonds in Japan yield about 1.5%. Looks great, doesn’t it? Trouble is, Japanese stock markets and economic growth have been sinking for over ten years. Now we wouldn’t want that, would we?



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