Monday, March 14, 2005

Interest rates and fiscal policy

Is it a conundrum that long term interest rates would stabilize or fall during a period when government controlled short term interest rates are rising?

Perhaps it could be under normal circumstances, but the interest rate environment of the past four years, and in particular since November 2002 when the Federal Reserve cut overnight lending rates all the way down to 1.25%, followed by another quarter point cut in June 2003, has not been normal. The FED, arbiter of the punch bowl, was accomodating (spiking the punch) because of concern that the economy was so lacking in party spirits that a whole new form of drug might be necessary to bring some life back into the party.

By the spring of 2004, it was clear that the FED no longer needed to spike the punch. The dollar was in free fall, and oil prices were approaching record highs. Wage inflation, which the FED has targeted like a teenager eyeing the punch bowl for the past 23 years, was still nowhere to be found, but other traditional price signals made it clear that it was time for the FED to at least stop spiking the punch, even if it wasn't yet time for the FED to take the traditional role as party pooper.

Five interest rate hikes and an election later, long term rates were as low or lower than they had been in the months leading up to the first of five quarter point hikes in the overnight lending rate. Alan Greenspan coined the idea that it was a "conundrum" why long term rates had not responded to the FED's move.

What was going on? Was the FED really baffled about what HAD BEEN going in the bond market, or was the FED sending a signal to inflewence the FUTURE moves of the bond market? Is there really any question?

It seems pretty clear to me that short term rates were, indeed, accomodative around the 1% range, particularly in light of the uptick in prices. And, the accomodation was more than just a nudge or two. The FED had all the traditional stops pulled out and was just short of resorting to dropping $100 dollar bills in selected neighborhoods. It was rather remarkable that US dollar denominated debt was still in demand as of the spring of 2004. The FED signaled it would bring overnight rates back to a normal range (3% to 5%, perhaps, is a "normal" range within one standard deviation at present) at a "measured" pace.

"Measured", we learned, meant a quarter point at a time and only at scheduled intervals. Hey, bond market, party on! With knowledge that accomodation was being quietly withdrawn, it was rational for long term bond holders to be modestly exuberant in the knowledge that the FED was fighting inflation by cutting back on it's own excesses, but that short rates would stay low enough for a year that rising short rates wouldn't put any serious pressure on demand for higher intermediate and long rates.

NOW we've gotten to a place where short rates are getting closer to normal, and where continued upticks might have some traction in terms of traditional inflewence on the rest of the bond market. From here, the slack has been essentially taken up - or if it hasn't yet been taken up, slack indicates the inflation genie is out of the bag.

Short rates won't be DRIVING the inflation genie - fiscal policy and the trade imbalance are in the drivers seat. But the bond market might look to the FED for "signals", and a "conundrum" is of the same genus if not the same species as "irrational exuberance".


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