June 15, 2005
As far as I can fathom, there are three explanations for the apparent “conundrum” that Fed Chairman Alan Greenspan continues to address.
The conundrum is that yields on ten year government bonds are lower today than they were when the Federal Reserve began raising their interest rate targets from 1 percent about a year ago. Normally, such as in 1994, the initial increase in short term rates leads to higher long term rates as well. Some rise in long term rates initially happened but then rates settled back to less than 4 percent yields.
Explanation one is that the Fed has achieved balance in the bond market and no longer needs to raise short term rates. A realization that no further gains in short rates, if it is correct policy, would establish the normal 0.9 to 1.2 percentage point gap between overnight and 10 year money that investors normally believe to be necessary to compensate for risks of rate fluctuations over a ten year period.
While some TV analysts are making the above case, it almost certainly is not correct. Even Dallas Fed President Dick Fisher expects at least one more increase in short term rates. That would provide only about a 0.65 percentage point compensation for the market risk faced by investors over ten years. Historically, that is not enough.
Furthermore, economists and futures markets for federal funds all believe that a minimum of 3.5 percent rates will be reached for overnight money. This is inconsistent with 10 year yields below 4 percent when bond markets are in balance.
Explanation two is that the Fed will push until a recession is inevitable in the next few years. Then rates will need to be cut sharply again to restore economic growth. Over the next ten years, that would mean a period of low overnight rates can again be expected despite the current increase in those very rates.
A ten year bond with the same credit risk should provide a yield equivalent to all the overnight rates expected over those ten years (along with an insurance premium for forecast error, which is the reason for the additional yield). So, investors may be forecasting significant weakness, requiring Fed intervention with lower rates in the not too distant future.
Wall Street analysts have discovered that higher short term rates than long term rates almost always predicts a recession ahead (about 11 to 18 months ahead). We do not yet have such a condition, but further increases in short term rates could bring that about.
I will not deny that a recession is possible if the Fed persists in raising short term rates. However, if such weakness occurs, I think it already is baked in the cake without further Fed action. Just as the bursting of the internet bubble led to a recession, the bursting of a real estate bubble could do the same.
The conundrum is that if the Fed does not raise rates, the bubble will grow until it bursts on its own, much as the speculation in Japan did in the latter 1980s. If the Fed raises rates to starve the bubble, the higher rates could cause recession (though not as severe as the one that happens if the bubble bursts). Could the Fed already be faced with the undesirable choice of staging a mild recession to avoid a substantial one?
Clearly, long term bond investors think the recession prospects no longer are minor.
Explanation three is that the world has so much liquidity that Fed action to exhaust that liquidity will not be very successful. The European Central Bank has been holding rates down regardless of economic growth in Europe. They now are confronted with economic slowing amid little ability to use stimulative monetary policy, because they never removed such accommodation.
Because economic growth looks less appetizing in Europe, monetary accommodation is flowing to China and then to the United States. As I have mentioned in previous columns, those world nations that are running large trade surpluses have a more than normal desire to hold 10 year U.S. government bonds.
I think reality is a little bit of explanation two and a great deal of explanation three. If so, the Fed should continue to establish neutrality in overnight bond rates, even if those rates jump above the 10 year yield. If this creates recession, then recession probably cannot be avoided. To follow an alternative policy could create an even greater fallout when rising housing equity that is feeding consumption eventually stops, as it surely will.