Low Long-Term Rates Will Force the Fed to Speak Up

The central bank needs to do more than raise short-term rates to push long-term rates in the same direction.

By Jerome Idaszak, Associate Editor, The Kiplinger Letter

February 2, 2005

The Federal Reserve will continue to increase short-term interest rates, as it did Wednesday for the sixth time since June, to contain inflationary pressures. Meanwhile, expect Fed officials to start talking up long-term rates as well. They want to discourage a rise in speculative buying of housing, stocks and other assets as well as overzealous merger or stock-listing activity. The Fed doesn't want to see the reemergence of 1990s-style bubbles, which the easy credit offered by low long-term rates may well fuel.

The latest quarter percentage point hike by the Federal Open Market Committee (FOMC) brings the federal funds rate—the rate that banks charge one another for overnight loans—to 2.5%. Banks, in turn, will raise their prime lending rates to 5.5%, leading to higher rates on lines of credit to businesses, adjustable rate mortgages and other loans. We expect the fed funds rate to end the year around 3.75% and the prime, at 6.75%.

The boost in short-term rates will tighten credit, helping to keep the economy growing at a measured pace and thus holding inflation pressures at bay. The policy seems to be working: Fed Chairman Alan Greenspan's inflation yardstick of choice, the core personal consumption deflator, rose only 1.7% in 2004, well within the Fed's perceived comfort zone of 1.5% to 2%. Gross domestic product growth is likely to come in at a healthy 3.5% this year, albeit down from 4.4% last year.

However, unlike in past Fed rate-tightening cycles, long rates—which are set by the bond markets—aren't following suit. The 10-year Treasury note is yielding around 4.1%, about a half-point below where it was in June. The 30-year fixed-rate mortgage is also a half-point lower. As a result, rates are doing little to cool activity in home buying and in borrowing by companies to finance mergers and acquisitions.

The Fed has some weapons at its disposal to try to jack up long-term rates. At the top of the list would be to shock financial markets into action by raising the short-term federal funds rate a half a percentage point instead of taking the measured path of quarter-point increases. Such a step is unlikely, however, because it risks sending financial markets into a tailspin and slamming the brakes on the economy.

Another option, also unlikely, is for the Fed to intervene directly in long-term rates by buying up Treasury bonds. It's a tricky proposition, given that the T-bond market is in the trillions of dollars. Trying to target a particular long rate would be nearly impossible.

Instead, watch for Greenspan to soon warn about the risk of low long-term rates fueling inflation and of "excessive risk-taking," as mentioned in the minutes of the Dec. 14 FOMC meeting. Greenspan is likely to chime in when he appears before House and Senate financial committees in mid-February.

It's not entirely clear why long-term rates haven't budged. During a Fed rate-tightening cycle in 1994, 10-year Treasuries rose almost two percentage points to about 8%.

There are a couple of theories about the current situation, and the reality is probably a combination of the two. The first, says Richard DeKaser, chief economist with National City Corp., is that "the Fed has a lot of credibility" and may be its own worst enemy. In other words, traders in the bond market think that the Fed will do whatever it takes to hold inflation at bay. So bond buyers have little impetus to demand higher long-term rates because they don't see inflation rising in the future.

The other theory attributes the current situation to heavy overseas buying of Treasuries, especially by China and Japan, to recycle the billions of dollars they purchase to keep their own currencies from rising against the dollar. Foreign central banks' holdings of U.S. Treasury bills and bonds have soared in the past few years. After staying at $600 billion to $650 billion from 1997 to 2002, holdings by central banks have shot up to almost $1.1 trillion. In the last fiscal year alone, Japan's central bank bought $225 billion, an amount just over half of the U.S. budget deficit.

Apart from any action by the Fed, another trigger for rising long-term rates could be a change in Treasury-buying habits by Japan or China. This looks increasingly likely as China starts making noises about allowing its currency, the yuan, to go up a bit against the dollar. Chances are that the Asian nations will begin to slow their Treasury purchases later this year.

A change in sentiment about rising U.S. federal budget deficits could also do the job for long-term rates. For now, there's willingness in the bond market to give the White House leeway on its pledge to hold the line on spending. But a lot depends on whether the situation in Iraq stabilizes, allowing the U.S. to ramp down its burdensome military spending there. If bond traders think that the deficit is here to say, they'll bid up long-term rates.

When long rates do move, there may well be a sudden upward burst followed by another leveling off. That happened in summer 2003, when the 10-year note hit bottom at 3.1% in mid-June and soared to 4.6% in mid-August. It has been up and down since then, in a narrower range of about 3.7% to 4.7%. For now, we expect the 10-year Treasury to yield 5% to 5.25% at year end.