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Why the fiscal cliff deal could lift interest rates

January 07, 2013

| MoneyRates.com Senior Financial Analyst, CFA

Congress and President Obama may have reached a deal to avoid the fiscal cliff, but the agreement still leaves some key questions about government finances unanswered. As things stand now, a number of factors suggest that mortgage rates and interest on savings accounts could move higher by the end of 2013.

What the deal accomplished

The most prominent aspect of the deal to avoid the fiscal cliff is that it preserved the Bush-era tax cuts for most Americans -- only individuals making more than $400,000 a year and households making more than $450,000 a year will see their federal income tax rates rise. Wealthy Americans will also pay more in capital gains and estate taxes under the agreement, while more people will be able to avoid the alternative minimum tax, which means that those people will be able to take better advantage of tax deductions. The deal also delayed a round of automatic spending cuts that was due to go into effect January 1.

The immediate goal of this deal was to avoid snuffing out an already fragile economic recovery. Most experts agreed that the economy was not growing at a strong enough rate to overcome the drag on growth that result from a combination of widespread tax increases and federal spending cuts.

What the deal didn't accomplish

The deal did not completely spare the average taxpayer. A temporary break on Social Security taxes was allowed to expire, meaning that most people will see a small hit to their paychecks from now on.

Perhaps more significantly in the long run, the deal did little to address the looming problem that inspired the fiscal cliff in the first place -- the growing federal budget deficit. The Congressional Budget Office estimates that the deal will add $4 trillion to the deficit over the next 10 years.

The budget deal also failed to address the country's debt limit, which sets up another confrontation between Democrats and Republicans within a couple of months. Between that and the fact that the fiscal cliff's spending cuts have only been delayed rather than cancelled, it means that the economy may yet have to withstand some level of spending cuts.

The impact on interest rates

Because the budget deal leaned more toward economic stimulus rather than deficit reduction, it could help reverse the trend that has seen interest rates decline drastically over the past few years. That's bad news for potential borrowers, but good news for depositors who have seen interest on their savings accounts and other deposits all but disappear.

Anything that stimulates the economy has the potential to increase the demand for capital, which creates upward pressure on interest rates. It could also help bring unemployment down, which would hasten the day when the Federal Reserve can back off on its current policy of active intervention to lower interest rates. In addition, because the deal looks like it will add to the deficit problem, it may raise credit concerns, which would also contribute to higher interest rates.

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