-- WSJ(12/31) Column: Silver Bullets For The Bear? --
By Jeremy J. Siegel
(Editor's Note: Mr. Siegel is a professor of finance at Wharton.)
When the Fed lowered the funds rate to 1.25% early last month, many believed
the economy was ripe for a rebound. But with the consumer ending the year on a
soft note, some fear the Fed is running out of silver bullets, those delightful
reductions in short-term interest rates that have always pulled the market and
the economy out of past doldrums. Is it possible that the U.S. could head into a
Japanese-style slump with the Fed running out of firepower to spur the economy?
Alan Greenspan seems unconcerned, and has recently reaffirmed that the central
bank has more tools in its policy kit than just setting the federal funds rate.
He fondly recalled the Fed's policy of "pegging" the interest rate on long-term
government bonds just after the Second World War, when the Fed supported
long-term bond rates at an extremely low level of 2.5%.
But I believe it would be much harder to set long-term interest rates than Mr.
Greenspan implies. In today's markets, it may take the help of both the Treasury
and the foreign-exchange markets to revitalize the economy if reductions in the
funds rate don't do the trick.
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To understand why this is true, one must grasp the nature of the federal funds
market. The Federal Reserve can easily peg the federal funds rate because this
rate is determined by the supply and demand for bank reserves and the Fed is the
sole supplier of these reserves. Reserve balances at the Fed are small -- less
than $15 billion -- so the central bank, through buying and selling just a few
billion dollars of government bonds, has a huge impact on the interest rates in
this market. Furthermore, since fed funds mature in only one day, expectations
of what will happen months or years down the road have little bearing on the
funds rate. The fed funds rate, which anchors the short end of the "yield
curve," becomes an interest rate that can easily be manipulated by the central
bank.
But once you travel up this yield curve into longer maturities, circumstances
change radically. Not only does the actual supply of government securities
become much greater, but the yield on these securities is dominated by
expectations of inflation, real economic growth, and Fed policy in the future.
When Mr. Greenspan referenced the ability of the Fed to peg long-term interest
rates after World War II, he was referring to a time when there were nowhere
near as many bond traders with huge resources at their disposal. Today, hedge
funds use highly leveraged interest-rate futures, options, swaps, and other
derivatives that can inundate the market with trillions of dollars of those
securities, overwhelming the size of the Fed's entire bond portfolio. One need
only recall how George Soros broke the Bank of England 10 years ago by shorting
the British pound in the face of massive purchases by the central bank.
If the Fed buys long-term bonds, trying to force their interest rates down,
but traders believe that this action will stimulate the economy or cause
inflation, long-term rates will rise, not fall. "Bond vigilantes" have often
sent long-term interest rates in the opposite direction to the movement of the
federal funds rate in anticipation of the effect of the Fed's action. For
evidence of this, note that the rates on long bonds initially moved higher after
the Fed's latest rate cut on Nov. 6.
If the bond traders are right and the economy picks up, then all is well and
good. But what if they are wrong? What if the Fed rate cut does not stimulate
growth as bond traders expect? How can the Fed push the long rate down in spite
of bond traders sending rates in the opposite direction? One solution is to
enlist the help of the Treasury to change the maturity structure of federal
government bonds, reducing the supply of long-term debt by selling a like amount
of short-term bonds. Short interest rates would not rise because they are
closely linked to the fed funds rate, which is controlled by the Fed, but long
rates would drop because the supply of long-term government bonds would fall.
Bond traders always take note of significant maturity changes announced by the
Treasury. We saw one manifestation of how this strategy would work two years ago
when the Treasury announced it would no longer issue the 30-year bond and
long-term bond rates fell dramatically. Certainly the Federal Reserve can shift
the maturity structure of the bonds held by the public by selling short-term and
buying long-term bonds from its vast portfolio of government securities. But the
market would take the shift by the Treasury as far more definitive and
significant.
But this isn't all that can be done. It is possible that even lower long-term
rates will not stimulate the economy. After all, Japanese long-term bonds are
currently below 2% and Japan is still in an economic slump.
Here is where the change in markets between the 1950s and 2000s can help,
instead of hinder, the Fed. A half-century ago, the dollar was rigidly pegged to
all other world currencies. In fact, monetary policy had to be mindful of
international capital flows in order to maintain those fixed parities. But under
today's floating exchange rates, there are no such restrictions. The Fed can
continue to expand the money supply, even as interest rates are driven towards
zero. This policy, called "quantitative easing," will likely induce foreign
exchange traders to sell these excess dollars, pushing down the dollar exchange
rate.
Recently, newly appointed Fed Governor Ben Bernanke questioned the usefulness
of these actions and commented that the Treasury, and not the Fed, is
responsible for dollar policy. But foreign exchange traders understand that the
central banks are the ultimate arbiters of exchange rates because they control
the money supply.
A falling dollar, although not a positive development for consumers in the
long run, would serve to boost aggregate demand in the short run. Not only would
U.S. exports become cheaper on world markets, but import prices would rise. This
would go a long way toward mitigating the "imported deflation" from China and
other developing countries.
A little inflation in an economy where many corporations and individuals are
saddled with debt would be an encouraging development. In fact, there is a
strikingly positive correlation between producer prices and profits in the short
run, as pricing power is a key driver of corporate earnings. I think today that
a softer dollar is a positive development for both the economy and the stock
market.
Nevertheless, I do not believe that the Fed will have to reach into its tool
box of extra tricks, as the current short-term rates are likely to work their
magic next year. But if the Fed needs to stimulate the economy further, it
should not hesitate to continue to cut rates for fear that it is running out of
silver bullets. It won't be quite as easy as Mr. Greenspan indicates, but the
Fed, in conjunction with the Treasury and the foreign exchange markets, can get
the economy on the road to recovery.
(END) Dow Jones Newswires
12-30-02 2013ET- - 08 13 PM EST 12-30-02
31-Dec-2002 01:13:00 GMT
Source WSJ - Wall Street Journal |
