What's driving interest rates today? In the broadest sense, rates are ordinarily driven by expectations of inflation. In a business cycle, we progress from a downturn or recession to economic recovery, to acceleration, to maturation and, finally, back to a downturn.

In post-World War II business cycles, as the economy reaches the acceleration phase, the demand for both money and commodities increases, which moves short-term interest rates and prices higher. As the maturation phase is reached, the demands for capital and labor are intensified and the economy closes in on full employment. Consumers have more income with which to purchase more products, which helps to create a "demand-pull" type of inflation. To counter these events and to "cool down" the economy, the Federal Reserve "tightens" monetary policy, which forces short-term interest rates much higher.

Eventually credit becomes too expensive to use, the economy slows, inflation falls, interest rates follow suit until they reach a level where businesses begin to borrow again, and we move from the recession phase into the recovery phase of the cycle, and it all starts over again. The average length of this cycle is 3 to 5 years.

Long-term interest rates are directly affected by expectations of inflation. If the buying power of one's currency is going to be eroded by inflation, investors will demand a higher interest rate to offset its loss.

With the "internationalization" of the world's economies and financial markets, political, financial and economic events occuring in one major industrialized country can easily affect the economic and financial condition in other countries.

Assuming that there will be no major confrontation in the Persian Gulf, one must believe that inflation is still a major threat to justify today's nominal interest rate level as high as 9.50 percent on the long Treasury. Some analysts are now saying that inflation in the United States may only be 4.5 percent this year. This means that the "real interest rate" is 5 percent (9.50 percent minus 4.50 percent), which is considerably above the average historical real rate of 3.0 percent.

Currently, inflation isn't a big problem in the United States or with our trading partners. So either the markets are anticipating greater inflation in the future, both the nominal and real interest rates must correct downward, or something else is driving interest rates.

It would appear that the "something else" is once again the dollar. With the federal budget deficit at the core of the problem, and with the resulting trade and current accounts in deficit, the dollar becomes the linchpin in the entire equation. With little likelihood that these "deficits" will improve soon, the dollar is especially vulnerable, remaining stable only when interest rate differentials sufficiently favor the United States.

The interest rate differential between the United States and abroad has recently been affected by the rise in foreign interest rates, even in those countries that enjoy low inflation rates. Unless interest rates abroad continue strongly upwards (an unlikely event), then hopefully it will not take much more of an increase in the U.S. rate to defend the dollar, assuming that inflation remains around 4.50 percent in the United States. In the event interest rates in the United States move considerably higher, then the high real interest rate would threaten the continuation of the economic expansion in the United States.

The Treasury will offer a two-year note on Tuesday, a four-year note on Wednesday and a seven-year note on Thursday. They should return 8.25 percent, 8.70 percent, and 9.15 percent, respectively.

James E. Lebherz has more than 28 years' experience in fixed-income investments