Higher Interest Rates: One Cheer for Bond Vigilantes

The Dow's reaction to higher rates on Treasury notes yesterday -- a nearly 200-point drop -- is the sort of thing that will depress you if you spend too much time caught up in market's daily mood swings. Sure, there are lots of good reasons not to like higher interest rates, especially when you're praying for an end to a recession and real estate price collapse.

To name the obvious downsides, higher rates make it more expensive for businesses and consumers to borrow and start spending again. That prolongs the recession. The 10-year Treasury note is linked particularly tightly to mortgages. And higher mortgage rates could definitely stand in the way of a real estate recovery. That, too, prolongs the financial crisis.

In the long run, though, those higher rates are a sign of something healthy: bond investors are starting to worry more about inflation than deflation. Bond investors hate inflation, which erodes the value of a fixed income, and so they demand a higher yield to compensate for the risk. That can put the brakes on the economy, but in doing so, it eases the bottlenecks that can cause inflation. It's a built-in check and balance of the market system -- the bond market vigilantes at work. One extreme example: The punishingly high interest rates of 1980 and 1981, which finally broke the back of the Great Inflation of the 1970s.

Granted, there's no sign of inflation in the near future, but eveything in economic theory and history suggests that the money the Fed and the Treasury are pumping into the economy will one day catch fire as inflation. Up to this point, the Treasury market was strangely indifferent to that possibility, and the only firebreak in the system was the Fed's reassurance that it could turn off the money flow at just the right time to avoid inflation without slowing the economy down. It's a bit like the old Bill Cosby joke about how he'd save himself in a airline crash by jumping up just before the plane hit the ground. I feel a lot better knowing that the bond vigilantes are back on the beat.

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