To: JDinBaltimore who wrote (28247 ) 10/3/1999 12:04:00 PM From: michael r potter Read Replies (1) | Respond to
"On a Macro Level, Financial Markets will Determine Rates." True, and to follow up, the financial press persist in perpetuating the myth that the Fed determines Rates [usually implied to mean long rates]. The Fed can influence and does set some short term rates. Long rates are determined by other [market] factors including the perception of inflation bond holders can expect [that will reduce their return and principal] over the life of the longer dated bonds. Using an extreme example will highlight the Feds role and how it affects long rates. If the Fed decided to raise "rates" by 2 1/2% tomorrow, what would this do to long rates? After the initial shock, long rates would decline, as the economy would slow dramatically and any inflation building in the system would be cut very short. Obviously demand for credit would dry up. Conversely, if the Fed lowered "rates" by 2 1/2%, the long bond yield would rise, as demand for credit and inlationary expectations would rise [the enemy of long term bond holders]. So, contrary to what is usually implied in the press, Fed tightening is positive for the long bond other than short term [mis]reactions based more on emotion. There is one possible counter argument to this. That is that if the Fed raises rates to cool the economy and inflationary expectations, it is indeed negative for the long bond. The reason is that if the Fed is successful in slowing the economy enough, overall tax revenue slumps because of rising unemployment, less hours worked, and greatly reduced tax revenue from capital gains. Corporate and individual tax revenue would be much lower than otherwise. The Government surplus would be much less or possibly disappear, thus putting pressure on long rates. IMO, this is not sufficient argument, as the slower economy would reduce demand for credit and expectations for inflation which are most important in determining long rates. The dollar and foreign demand for US long bonds are intertwined in the whole scenario, but it is beyond my current expertise to determine how that would play out in the two above cited extreme examples of Fed action. A lot of feedback loops get set in motion of which I can not determine the net effect [on long rates]. Maybe others here can. Mike
