Fed's Rate Boosts Backfire by Stimulating Economy (Update1)
Feb. 22 (Bloomberg) -- Federal Reserve Chairman Alan Greenspan calls it a ``conundrum.'' Former Fed colleague Laurence H. Meyer calls it ``extraordinarily unprecedented.''
The Fed has raised its target interest rate six times since June 30, intending to prevent the U.S. economy from overheating later this year. Instead, the increases are having the opposite effect: They're spurring the economy, not reining it in.
``Rather than the rate hikes slowing the economy as some analysts had expected, they've acted as a stimulant,'' David Malpass, chief economist at Bear, Stearns & Co. in New York, said in an interview.
When the Fed raised the overnight bank-lending rate in the past, long-term interest rates rose as well. This time around, investors took comfort in the Fed's commitment to what it calls a measured pace of rate increases as a way to head off faster inflation. Instead of rising, yields on 10-year Treasury securities and rates on 30-year mortgages fell. Banks expanded their corporate lending and merger activity sped up.
``This is a unique experience,'' Meyer, a Fed governor until 2002, said in an interview. ``From the very moment the Fed began to tighten, long rates are falling. In 1994, the last time the Fed raised the rate significantly, ``long-term rates just shot up much more than most people were expecting,'' he says.
Puzzled Greenspan
Greenspan, 78 and in his final year atop the central bank, told Congress last week he's puzzled. The yield on the benchmark 10-year Treasury note has fallen more than 30 basis points to about 4.27 percent since June 30, the first of six straight meetings in which the Fed raised its target rate by a quarter- point to the current 2.5 percent. Gary Pollack, head of fixed income trading and research at Deutsche Bank Private Wealth Management in New York, which manages $12 billion of bonds, says that a yield reflecting the fundamentals of the economy and inflation would actually be between 4.5 percent and 4.75 percent.
``Bond price movements may be a short-term aberration, but it will be some time before we are able to better judge the forces underlying recent experience,'' Greenspan said in the text of his testimony to the Senate Banking Committee on Feb. 16 and the House Financial Services Committee Feb. 17. ``The broadly unanticipated behavior of world bond markets remains a conundrum.''
The benchmark 4 percent note maturing in February 2015 was little changed at 97 27/32 at 2:32 p.m. in Tokyo, according to bond broker Cantor Fitzgerald LP.
The unexpected booster shot creates a risk that easy money will spur growth, which in turn may accelerate inflation, Richard Berner, chief U.S. economist at Morgan Stanley in New York, said in an interview. Faster inflation is the very thing the Fed wanted to head off with higher interest rates.
Keeping Inflation at Bay
Keeping inflation at bay would mean ``short rates are going to have to go up considerably,'' Berner said.
Among signs suggesting the rate increases haven't damped consumer or corporate spending: Bank lending for commercial and industrial loans surged 6.6 percent since May 5, the month before the Fed began tightening. Mergers and acquisitions in this year's first six weeks reached the fastest pace since 2000. Housing starts unexpectedly rose 4.7 percent in January to a 21-year high after a 14 percent surge in December. The 30-year fixed-rate mortgage two weeks ago dropped to a 10-month low of 5.48 percent.
``It's an ideal time to put money to work,'' Paul Beard, treasurer at Sparks, Maryland-based McCormick & Co. Inc., the world's largest spice company, said in an interview. ``The feeling is that rates are going to continue to rise.''
Rising Forecasts
Growth forecasts are rising accordingly. In December, a monthly Bloomberg News economist survey predicted growth of 3.5 percent in 2005; the median estimate rose to 3.6 percent in this month's poll. A Feb. 14 survey by the Federal Reserve Bank of Philadelphia Feb. 14 showed 36 economists forecasting a 3.7 percent first-half growth rate.
``Policy is probably more accommodating than it was when the Fed had a 1 percent fed funds rate last year,'' John Ryding, chief U.S. economist at Bear, Stearns in New York, said in an interview. Given the decline in long-term rates while they boost the overnight rate, the Fed is ``running on a treadmill.''
Ryding expects the fed funds rate to reach 4.5 percent by year-end and 5 percent in 2006. Berner, who forecasts 3.75 percent by year-end and 4.5 percent in 2006, predicts that ``even with that increased rate, inflation is going to rise.''
The situation isn't likely to alarm central bankers enough to speed rate increases, says Roger Kubarych, economic adviser to HVB America Inc. in New York and a former Fed economist.
Extra Stimulus
``I don't think the Fed minds it,'' Kubarych says of the extra stimulus. ``Top Fed policy makers really don't think the economy's that strong, and many of them are dovish on inflation. I think they'd like to see real economic growth of 4 percent to 5 percent and the unemployment rate drop below 5 percent.'' He says the Fed probably will adhere to its self-described ``measured'' pace of quarter-point increases.
For the moment, the Fed may be tied to a gradualist approach because members of its policy-setting Federal Open Market Committee are split, says Brian Westbury, chief economist at Griffin, Kubik, Stephens & Thompson Inc. in Chicago.
``There's a dichotomy, divergence of opinions on the Fed right now,'' Wesbury says. ``Some governors are worried about inflation and not worried about a slowdown in the economy. Others are believing inflation is well-contained.''
Commercial and industrial loans started rising in May, a month before the Fed raised rates, after declining steadily since January 2001. The Fed's latest survey of bank lending policies showed that banks relaxed standards for U.S. commercial and industrial loans during the most recent quarter.
Openness to Risk
``You are starting to see a little more openness to taking some risk,'' says Charles Shufeldt, executive vice president at SunTrust Banks Inc.'s corporate and investment bank in Atlanta. ``There is a little more confidence that the economy is going to hold up and you'll have time to make something like an acquisition pay.''
Bankers still see room for corporate borrowing to expand, says Robert Kelly, chief financial officer at Charlotte, North Carolina-based Wachovia Corp., the fourth-biggest U.S. bank.
``They are doing more than they were, but it's off a very low base,'' Kelly said in an interview. ``You will see continued improvement in numbers in the course of this year.''
Wells Fargo & Co., the No. 5 U.S. lender, said its commercial loans including real estate rose 9.9 percent to $95.6 billion in the fourth quarter from the year-earlier period.
Liquidity
``I've never seen this much liquidity in the marketplace,'' says William Zadrozny, chief executive officer of Siemens Financial Services, the Iselin, New Jersey-based lending unit of Germany's Siemens AG, in an interview. ``There's a lot of money available for companies to borrow.''
Charlotte-based Bank of America Corp. is arranging a $125 million acquisition financing for Briggs & Stratton Corp. that will allow the small-engine maker to buy Murray Inc., says James Brenn, chief financial officer of Briggs & Stratton.
John Daniels, who is in charge of Bank of America's credit products for midsized companies from his office in Chicago, says, ``The economy is picking up, our clients' sales are increasing and therefore their need to invest in capital expenditures and working capital has picked up modestly.''
There's no consensus about what caused the rally in the bond market in the wake of the Fed's series of rate increases.
Flawed Explanations
Greenspan cited, and then described flaws in, a variety of explanations cited by economists: that investors are concerned about economic growth amid high oil prices; that bond investors, once skeptical, are now convinced the Fed will raise rates gradually; bond purchases by foreign central banks; that mortgage investors seek longer-term securities because the average duration of outstanding mortgage-backed securities has shortened.
Stock prices wouldn't be rising and credit spreads wouldn't be narrowing if investors concluded the economy was stumbling, Greenspan said. ``This interpretation does not mesh seamlessly'' with what's going on in the markets, he told the lawmakers.
Bear Stearns' Malpass says bond yields are falling because credit markets ``are temporarily overwhelmed with excess liquidity'' in the U.S. and abroad. He predicted bond yields won't remain low if the U.S. economy strengthens significantly.
Arthur B. Laffer, chairman of Laffer Associates in San Diego and a supply-side economist, says the rise in long-term rates isn't the result of the Fed's action at all. Rather, he said in an interview, the Fed's own rate increases were spurred by earlier rises in interest rates on 90-day Treasury bills.
``The rise in the federal funds rate is an excellent interest- rate increase because it tells us that we're recovering,'' Laffer says.
Zadrozny, the CEO for Siemens' financing arm, doesn't expect the situation to last. Eventually, he says, bond investors will follow the Fed's lead and raise interest rates.
``Somewhere along the line, long rates are going to have to give,'' Zadrozny says. |
