If Interest Rates Turn Upside Down, Look Out
By JONATHAN FUERBRINGER
Published: July 31, 2005
ALAN GREENSPAN, the chairman of the Federal Reserve, is upbeat - but still worried. Inflation, energy prices and stubbornly low longer-term interest rates top his list of "significant uncertainties" about the economic outlook.
A Narrowing GapThe important question for investors is how these uncertainties will influence the central bank's course, with the federal funds rate, its benchmark short-term interest rate, having already climbed 2.25 points, to 3.25 percent, since June 2004.
Graphic: A Narrowing Gap graphics8.nytimes.com
Mr. Greenspan said in his recent semiannual testimony before Congress that he was concerned about the upturn in unit labor costs. And, of course, record oil and gasoline prices can also increase overall inflation. If worrisome signs of inflation persist, many analysts would expect the Fed to keep tightening.
But high oil and gasoline prices could cut the other way, as Mr. Greenspan noted, and slow economic growth. If slow growth is the problem, the Fed would be more likely to ease its tightening, analysts have said.
On the refusal of longer-term interest rates to rise, analysts are less sure of how the Fed would respond. On Friday, the yield on the Treasury's 10-year note was 4.28 percent, well below the 4.69 percent of June 29, 2004, the day before the Fed made the first of nine quarter-point increases in short-term rates. Mr. Greenspan said in his testimony that this stubborn behavior "is clearly without precedent in our recent experience."
Does this abnormally low 10-year yield, which has played a big role in keeping mortgage rates so cheap, mean that the Fed will have to raise short-term rates even higher than might be expected? Is that what it will take to increase mortgage rates and cool the housing boom that is fueling consumer spending? And was this the message that Mr. Greenspan was sending in his carefully worded Congressional testimony?
A close reading of the prepared text could lead to that conclusion. Mr. Greenspan moved from a discussion of the surprising behavior of longer-term interest rates directly into the froth in the housing market. And, he added, rising real longer-term rates are necessary to restrain the buildup in home equity that finances "a noticeable share" of consumer spending.
Robert V. DiClemente, chief United States economist at Citigroup, said that Mr. Greenspan "has come down pretty clearly on the side that these rates are a policy headwind and that you can see that in the housing market." Mr. DiClemente added that "the low bond yields are a factor that is encouraging the Fed to continue with the rate hikes."
Robert J. Barbera, chief economist at ITG in Rye Brook, N.Y., disagrees. He argues that the Fed has gotten the economic growth and inflation that it expected when it started raising the federal funds rate in June 2004. "It is not true that the stimulus from the bond yield has produced an economy they don't want," he said of Fed policy makers. "This does not make the case for a more dramatic tightening."
Only Fed policy makers will resolve this issue. But the debate suggests how difficult it must be for them to decide whether they have raised interest rates enough. Some Fed policy makers have acknowledged that it is only after they have finished raising rates that they realize they may have gone further than necessary.
James Glassman, senior United States economist at J. P. Morgan, says that there is one thing that will make the Fed leery of going too far. That is the prospect of a so-called inverted yield curve. The yield curve is the gradation of interest rates from short term to long term. It usually slopes upward; that is, longer-term yields are higher than shorter-term yields. It is inverted when short-term yields are higher.
WITH the yield on the Treasury's three-month bill at 3.40 percent and the yield on the 30-year bond at 4.47 percent, an inversion may not be far away. If the Fed raises its funds rate by a quarter of a point at each of its four remaining meetings this year, the yield on the three-month bill would be 4.40 percent, and it's possible that the 30-year yield would remain stubbornly low.
Wall Street, which focuses more on the portion of the curve between the Treasury's 2-year and 10-year notes, could find evidence of an inversion much sooner. On Friday, the 2-year yield was 4.01 percent, compared with a 10-year yield of 4.28 percent. A quarter-point increase in the fed funds rate in August could tip the balance.
That is a concern because many analysts, including those at the Fed, say an inverted yield curve is often a precursor of real trouble. "Nobody," Mr. Glassman said, "wants to invert the yield curve because you know there is a risk of a recession."
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