Fed vs Obama: Tax deal drives up rates

What the Federal Reserve giveth, Obama taketh away.

The U.S. central bank's $600 billion stimulus plan was supposed to lower interest rates. But President Barack Obama's tax deal with Republicans, by rekindling fears of budget deficits in the bond market, has pushed them higher.

As the Fed meets this coming week, the surprise shot in the arm from the fiscal authorities might strengthen the case of hawks at the central bank, who think the economy is already growing of its own momentum. They could argue to scale down the $600 billion in bond purchases announced in November.

The shift to fiscal stimulus implies that officials would be less inclined to extend the current program beyond the second quarter of 2011, said Richard Berner, an economist at Morgan Stanley.

On Wall Street, economists are busy revising up their forecasts for U.S. economic growth in 2011, in part because the tax deal will offer more short-term stimulus than many expected.

The package, which still needs congressional approval, extends the Bush-era income tax cuts, lowers payroll taxes by 2 percentage points and provides additional jobless benefits.

But it is unclear how much these new Wall Street economic projections factor in the renewed deficit fears that drove yields on benchmark 10-year notes to a six-month high last week. That's a question Fed officials will ponder when they meet on Tuesday.

Moody's Investors Service said it is worried the proposed tax reductions could become permanent when many of them come up for review in the presidential election year of 2012, hurting U.S. finances and credit ratings in the long run.

FEELS LIKE ARGENTINA

With Europe's crisis putting debt worries high on investors' minds, it is little surprise bond traders grew jittery at the prospect of more U.S. government debt.

The tax deal announcement came swiftly on the heels of a proposal from Obama's deficit-reduction commission that failed to win enough support to force legislative action.

Yields are up ... because we got $1 trillion in deficit spending with no signs of fiscal discipline on the horizon, said Julia Coronado, economist at BNP Paribas in New York.

It feels to global investors like the U.S. is becoming Argentina, she said. The back up in bond yield will rob much of the positive impact of the stimulus.

With the U.S. housing sector still mired in a prolonged rut, higher rates are certain to do more damage, curtailing refinancing activity and worsening a logjam in foreclosures linked to faulty documentation.

Against that backdrop, it is somewhat baffling to see forecasters frantically raising projections for economic growth. Berner at Morgan Stanley says the tax agreement could push growth up by as much 1.2 percentage points in 2011, putting it above 4 percent.

Given those projections, the bond sell off could simply signal expectations of stronger growth.

A more robust U.S. economy would be particularly welcome for the global economy at a time European nations are putting in place austerity budgets to deal with their debt troubles.

So far, the euro zone economy seems to be weathering the storm. Data on euro zone industrial production on Tuesday is expected to show a 1.3 percent rebound for October following a 0.9 percent pullback a month earlier.

Of course, if Europe's debt woes widened to engulf a large economy like Spain, that could swiftly come back to bite the United States.

Richmond Federal Reserve Bank President Jeffrey Lacker said last week Europe's troubles were largely manageable for the United States at this point. But he added a word of warning.

If broader, deeper growth effects were to hit Europe, if they were to enter a substantial recession again, bets would be off, he said.

(Additional reporting by Mark Felsenthal)