The financial papers and the futures markets indicate that interest rates are heading higher around the globe. So let’s assume rates are on the way up — and let’s be clear about what this means.
Rising interest rates are a result of an outward shift in aggregate demand in the economy, and the Bush tax cuts are the prime reason for that shift.
Since inflation is under control, the rise in rates is the result of a market-equilibrating process. In addition, the expectation of higher interest rates adds to the shift in aggregate demand in the short-run. In order to avoid higher financing costs in future periods, rational investors and consumers will accelerate their purchases of consumer durables. So, rising real rates add short-term fuel to the economic recovery.
The converse occurs during periods of falling interest rates: When rates are expected to drop further, purchases of consumer durables will be less than they would be otherwise. This explains the weak economic performance of the last couple of years. And if the economy is able to time the bond-yield market, it follows that the biggest impact on the economy’s aggregate demand will occur near the bottom of the market when rates begin to rise. This is precisely where the U.S. economy found itself during 2003.
The economic data of the last few months certainly support the view that the economy is gaining strength in the face of rising interest rates. Hence, if rising rates are the result of the recovery, it is silly to argue that rising rates pose a threat to the recovery.
In the face of higher rates what happens to market valuations? The answer is fairly straightforward. Bonds have fixed coupons, so their value unambiguously declines in this scenario. The issue with equities appears to be ambiguous: Both earnings and interest rates increase. But since rising rates are the result of a shift in aggregate demand, the higher interest rate cannot dominate the earnings effect — meaning that domestic asset prices will unequivocally rise. Have no doubt about it: This is a good time to be invested in equities.
Only a policy mistake on the monetary front and/or the trade front could derail this strong economic recovery. The Bush administration should stop trying to win Electoral College votes by adopting protectionist policies. These policies may produce gains in the states benefiting from the trade restrictions, but they also produce losses in the states consuming the protected items. In the end, the administration’s static analysis could subtract net votes, as there are more voters consuming imported items than producing those items.
Instead of promoting protectionism, the administration should come back to its pro-growth agenda. Here’s an idea: If the administration truly wants to buy votes in the states, why not invest in California? If Bush helps Gov. Arnold Schwarzenegger reactivate the Golden State, he’d have a shot at 54 electoral votes. And, as the saying goes, a rising tide lifts all boats. If California is in play, Bush would win additional marginal states.