What does rising Interest Rates signifies for the economy?

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In theory, bond investors are supposed to keep the behavior of governments and consumers in check by passing judgment on a nation's fiscal health. If things look bad, they sell, pushing up interest rates, and forcing policymakers and consumers to change course. From the outset of the financial crisis, critics warned that the combination of higher deficits (thanks to increased spending and collapsing tax revenues) and the Fed's easy money policies would ignite inflation, and act as a clarion call to the bond vigilantes.

But for two years, the bond vigilantes seemed to remain in hiding, as interest rates on U.S. government bonds generally fell, and then fell again. But in the past month, after laying waste to Greece and Ireland, the bond vigilantes have finally hit America's shores. In recent weeks, investors fearful about America's long-term financial future have pushed up the interest rate on the10-year and30-year bond. The yield on the10-year bond has risen from2.48 percent on November4 to about3.3 percent today -- an increase of33 percent. Rates on other government debt have also drifted upward. SmartMoney.com's living yield curve provides an excellent month-by-month graphic on how interest rates move over time.

The swift movement raises several questions for consumers, borrowers, and policymakers.

First, why are rates rising now? After all, the rout started after the Federal Reserve announced on November3 that it would take new extraordinary measures to keep interest rates low. In the next round of quantitative easing (QE2), the central bank pledges to purchase at least $850 billion in government debt through the end of June2011.

The answer: While the Fed is enormously influential in setting interest rates, it's not the only factor. Ben Bernanke & Co. directly control the Federal Funds rate -- i.e,.  the rate at which banks lend to one another on an overnight basis and that serves as a benchmark for short-term credit. The Fed Funds rate hasn't budged at all in recent months, and is unlikely to do so until the Fed decides it's ready to exit this emergency period of ultra-low interest rates. (Investors in Fed Funds rate futures predict that won't be until late2011 at the earliest.)

But the longer the term of the debt, the less direct control the Fed has over the interest rate, and the more other factors and emotions come into play. In recent weeks, there have been two important changes in investor psychology. First, the flow of generally positive economic data has pushed forecasters to increase their projections for growth in this quarter and next year. All things being equal, expectations of higher growth tend to push longer-term interest rates up. Meanwhile, the surprise tax deal between President Obama and Congressional Republicans has (a) reinforced the consensus behind stronger growth for2011 and2012; and (b) heightened the concern over deficits. (Deficits for the next few years will be much higher than previously thought if the deal goes through.)

Higher interest rates mean you pay more for your money. But not everybody is going to be paying more. BankRate.com has an excellentmodule that shows weekly moves in interest rates on a variety of credit products, from credit cards to auto loans.

The most immediate impact of higher long-term government borrowing costs will be seen in the arena in which consumers borrow for the long-term: mortgages. As the chart on Bankrate shows, interest rates on30-year mortgages have spiked in recent weeks, to near five percent. And so to the potpourri of troubling housing news -- excess supply, foreclosures, a weak job market -- we can now add higher rates. In the absence of what finance types used to refer to as "innovative mortgage products" (you know, exploding ARMs, negative amortization bombs, and other funky products), higher rates will make it more difficult for home sellers to get their asking prices in glutted markets. They're also bad news for home buyers, who will have to adjust their sense of how much house they can afford.

But most borrowing done by consumers and businesses is shorter-term debt. And there hasn't been quite as much movement in this area, in part because that's where the Federal Reserve is now focusing its firepower. The New York Fed, charged with carrying out the program of quantitative easing, announced in November that63 percent of its new purchases would be of bonds that mature in2.5-7 years, while only6 percent of purchases would be of bonds that mature in10 or more years. "Under this distribution, the Desk anticipates that the assets purchased will have an average duration of between5 and6 years."

And so even though bond markets broadly expect higher interest rates, there's been less movement in the rates for shorter-term credit. Bankrate.com shows that rates on auto loans are actually down slightly from the previous week. (Keep in mind: all these figures are national averages.) Rates on Home equity loans, another credit sector pegged to short-term interest rates, haven't changed much either.

For now, companies and individuals with excellent credit who want to borrow money for a few years -- from a bank, or from the bond market -- aren't finding that conditions have changed. With credit cards, there's long been a sense that the interest rates charged bear little relationship to the overall interest rate climate. Individual credit scores, delinquency and charge off rates, the need of banks to goose profits, and banks' relative level of greed/aggression can all be more powerful influencing factors on credit card rates than the shape of the yield curve. The New York Timesreported Monday, for example, that credit card companies are again pursuing more risky borrowers. For what it's worth, Bankrate.com sayscredit card rates were essentially stable during November.

As noted, the shortest-term rates haven't budged much at all. Which means that you and I will continue to lend money to banks at extremely low rates. In the weeks since the bond market rout started, rates on one-year certificates of deposit have actually fallen.

So, just as the banks are able to increase the price they charge you for long-term money, they're lowering the price they pay you for short-term cash. Somehow, the banks always seem to win

(1)Rate of Inflation is more, necessitating reducing it by hiking interest rate.

(2)Money supply is less.So interest rate will go up.

(3)Purchasing Power is being reduced.