Greenspan's Real Conundrum Isn't Long-Term Rates: Caroline Baum
quote.bloomberg.com
June 7 (Bloomberg) -- Ever since Federal Reserve Chairman Alan Greenspan made ``conundrum'' a household word in February, the term has been used to describe the behavior of long-term interest rates.
Specifically, this is the first time in recorded financial history that the Fed has jacked up short-term rates only to find long-term rates exhibiting a mind of their own. The yield on the 10- year Treasury note is about 75 basis points lower than it was before the Fed first raised rates on June 30, 2004. The overnight federal funds rate is 200 basis points higher.
So what's a good central banker to do? Will the Fed continue to boost short-term rates, even if it means inverting the yield curve, in an attempt to normalize rates to some unknown neutral level and to skim the froth off the housing market? Or will policy makers heed the message of the market encapsulated in the flattening yield curve and call it quits? This is Greenspan's real conundrum.
Dallas Fed President Richard Fisher's ``eighth-inning'' baseball metaphor last week notwithstanding, there has been nothing from the Fed to suggest an end to the cycle of rate increases, which have boosted the funds rate from 1 percent to 3 percent in eight 25-basis-point increments.
Inflation Signals
The statement following each meeting reiterates the belief that monetary policy remains accommodative. Compared with the year- over-year increase in the consumer price index of 3.5 percent, the inflation-adjusted funds rate is negative. (Translation: Banks are being paid to borrow.) The real funds rate has been below zero for almost three years, the longest stretch since the mid-1970s, hardly halcyon days for monetary policy.
Fed officials have said in every way except via the language in the policy statement that they're more concerned about accelerating inflation than slower growth. Given their focus on wages as the driver of inflation, the news last week that unit labor costs in the non-farm business sector rose at a 4.3 percent year-over-year rate flashed yellow on their radar screen.
The actual inflation news isn't all that great either. While the CPI excluding food and energy was unchanged in April from the prior month, core services prices (services excluding energy) rose at a three-month annualized rate of 3.8 percent, challenging the notion that the current inflation is ``all energy.'' As recently as January, core services were rising at a 2.4 percent pace.
Deconstruction Danger
Greenspan's dilemma -- his real conundrum -- isn't long-term interest rates, which are set by the market. It's what to do with the short rate.
When long rates fall spontaneously, without guidance from the monetary authority, it's not bullish for the economy. More people want to save at any given price than they did before.
Economists have cited all sorts of reasons to explain falling long rates, including Asian central bank buying of dollars and U.S. Treasuries, confidence in the Federal Reserve's inflation-fighting credentials and the low level of short-term rates. (Hey, I didn't say they made sense.) Deconstructing the yield curve -- seeking to explain why this time is different -- isn't the answer.
The yield curve is what it is: It's a shorthand guide to the stance of monetary policy.
It acquires its special, omniscient powers because it represents the relationship between a rate set by the central bank, with its magical powers to create and destroy reserves, and a market rate, which is where the supply and demand for credit intersect.
Listening to Long Rates
So, will the yield curve act as a constraining force on the Fed and forestall more than a couple of additional rate increases?
``I don't think you'll ever hear Fed people explain it that way, but the respect for the market voice has to weigh heavily on their decisions,'' says Jim Glassman, senior U.S. economist at JPMorgan Chase & Co. ``The market is the most reliable signal of equilibrium.''
Besides, ``if interest rates are so artificially low, why isn't the economy demonstrating the kind of energy you'd expect?'' Glassman asks.
Let's assume the Fed fulfills market expectations for 25-basis- point rate increases at the June 30 and Aug. 9 meetings, putting the funds rate at 3.5 percent. There is no reason to expect long- term rates to get with the program at this juncture and move higher.
Down Memory Lane
So come the Sept. 20 meeting, Fed officials will be confronted with a pancake-flat yield curve. What will Greenspan do with the short rate?
With his term as a Fed governor ending next January, he might want to take a trip down memory lane and reprise some of the more memorable phrases of his 18-year career as Fed chairman....
The time is Feb. 22, 1995. Greenspan is on Capitol Hill to deliver the Fed's semi-annual monetary policy report to Congress. The Fed has just raised the funds rate to 6 percent, putting it a full 300 basis points higher than it was one year earlier.
After explaining that monetary policy acts with a lag, which required aggressive tightening to stave off ``inflation pressures not yet evident in the data,'' Greenspan switches gears.
``Similarly, there may come a time when we hold our policy stance unchanged, or even ease, despite adverse price data, should we see signs that underlying forces are acting ultimately to reduce inflation pressures,'' Greenspan says.
Easing is nowhere on the horizon. And the last thing Greenspan wants to do is goose the housing market by giving markets the green light.
Still, there may come a time in the not-too-distant future when Greenspan's caveat is applicable again. |
