Rising Interest Rates Are Killing the Recovery

A sheaf of economic indicators this week indicates the recovery is in deep trouble.

The biggest shock was a sharp increase in bond yields. The yield on 10 year Treasury bonds rose to a peak of four percent, the highest since last August, before pulling back to 3.95 percent.

At the same time, the average rate on a 30 year fixed-rate mortgage increased to 5.57 percent from 5.25 percent in the previous week, according to the Mortgage Bankers Association. As a result, the index of refinanced loans plummeted 11.8 per cent. So the housing recovery -- the centerpiece of any rebound -- is clearly endangered. (My CBS MoneyWatch colleague Ilyce Glink is equally concerned about the housing market.)

There are two schools of thought about rising interest rates. One holds that increasing rates are a healthy sign of increased economic activity. The other says that increasing rates are a sign that the market is pricing in fears of inflation.

Economist Arthur Laffer, a prominent "supply side" economist who became famous in the Reagan Administration, predicted this week that the huge increase in government spending will lead to a big jump in interest rates and inflation. "We can expect rapidly rising prices and much, much higher interest rates over the next four or five years, and a concomitant deleterious impact on output and employment not unlike the late 1970s," Laffer wrote in the Wall Street Journal.

I wrote in an earlier column that inflation will be a potential problem in the future. But that danger won't rear its head for months or even years. As Moody's Weekly Credit Outlook noted this week, "So long as unemployment remains above the natural rate and -- more generally -- underutilization of economic resources persists, there will be no upward pressure on prices."

While initial jobless claims fell by 24,000 to 601,000 last week, the lowest level since January, the unemployment rate stayed at 9.4 percent, its highest level in years. That indicates there will be little pressure for wage hikes for some time to come.

As rates moved higher, there were some other disquieting signs in the economy. Oil prices continued to climb to a seven-month high, reaching $71.79 a barrel. That followed a report that crude inventories had fallen 4.4 million barrels last week. At the same time, gas prices hit $2.63 a gallon, a nine percent rise in just two weeks. While gas prices may not hit $4 a gallon as they did last summer, the rapid increase in pump prices will increasingly impact American pocketbooks. Money spent on gas won't be spent on consumer items, causing a drag on the economy.

How can oil prices go up if demand is weak? First, the dollar continued to fall last week. Since commodities like oil and gold are priced in dollars, when the dollar moves lower, it takes more dollars to buy that commodity. Secondly, there is increasing demand, just not in the U.S. In places like China and India, the economies are still growing, causing upward pressure on all commodity prices from copper to steel. Lastly, investors are increasingly speculating on oil prices by buying oil and holding it in oil tankers. That creates a shortage even when there is weak demand.

U.S. authorities are limited in what they can do to affect all this upward pressure on prices. Short-term interest rates are near zero. Jeffrey Lacker, president of the Richmond Federal Reserve Bank, said forecasts still point to the economy not growing again until next year. As a result, that "is likely to warrant rates to be kept low for some time," Lacker said. What's troubling is that with low interest rates, bond and mortgage rates should also remain low, but they are headed skyward. Fed Chairman Ben Bernanke needs to show the country that he has a plan to contain future inflation already in hand. That's the best way to show the market that inflation fears are not warranted.