Post by Moses on Jun 27, 2005 3:14:51 GMT -5
June 27, 2005
Low Rates Could Be Around for Long Term
By EDMUND L. ANDREWS
WASHINGTON, June 26 - Federal Reserve officials, who meet this week, are beginning to suspect that the perplexing decline in long-term interest rates is more than a temporary aberration.
The possibility has major implications for the economy, and it creates new puzzles for Fed officials on how they should respond.
On Thursday, the Fed is all but certain to raise the federal funds rate on overnight loans between banks by another quarter point, to 3.25 percent. That would be the ninth increase in the last year, and the central bank is expected to signal that it will continue to raise overnight rates at a "measured" pace.
But the real debate at the meeting is expected to be about the unexpected decline of long-term interest rates, which have kept mortgage rates at their lowest level in decades and fueled what many analysts fear is a bubble in housing prices.
Alan Greenspan, chairman of the Federal Reserve, said in February that the low long-term rates were a "conundrum" but might simply be a "short-term aberration."
But Mr. Greenspan and other senior officials are now suggesting that the change is more enduring. The debate is over why the change has occurred, and different theories lead to sharply disparate conclusions about the best way to respond.
"My sense is that people think this could be the new reality, that this could be fundamental, that it could be long-lasting," said Laurence H. Meyer, a former Fed governor and now vice chairman of Macroeconomic Advisers, a forecasting firm.
Mr. Greenspan, testifying before Congress earlier this month, described the trend as profoundly important and "clearly international in origin."
"How we integrate it into the basic underlying monetary policy structure is something we're spending a considerable amount of time on," he added.
The term premium - the added payment that investors demand to cover the uncertainty of holding long-term bonds - has shrunk to almost nothing. Investors appear to assume that the overnight rate will be about 3.75 percent by the end of this year. But the yield on 10-year Treasury bonds remains about 4 percent.
One school of thought holds that low bond yields are a harbinger of slowing economic growth, which would reduce demand for credit in the future. Another school holds that global investors have lower inflation expectations than in the past, which reduces the risk of holding long-term bonds. If either theory is correct, the Federal Reserve would have less need to fend off inflation and could stop raising short-term rates at a much lower level than in the past - perhaps below 4 percent.
But yet another theory holds that long-term interest rates may have been depressed by other factors, including a "savings glut" around the world and efforts by Asian central banks to keep the value of their currencies down by buying United States Treasury securities.
If that is true, the flood of foreign money into the country could be diluting the Fed's effort to prevent inflation. That would imply that the Fed needs to raise rates more than many investors are expecting.
Mr. Greenspan, testifying before Congress on June 20, was skeptical about theories based on low inflation expectations or on an impending slowdown. "A narrow gap between short- and long-term rates is often misread as though we're about to tilt into a recession," he said. "If that is the case, then the hypothesis that it is a weak economy which has been driving down interest rates is probably not correct."
He also expressed concern that low long-term rates had contributed to "froth" and might be feeding inflationary pressures. "And that's something which, needless to say, we are focusing on very extensively."
Other officials have been more optimistic. William Poole, president of the Federal Reserve Bank of St. Louis, has argued several times that long-term rates are mostly driven by investors' expectations of long-term inflation. Even though the Fed has raised short-term rates, Mr. Poole said in a speech on June 14, investors have had no reason over the last year to expect higher long-term inflation. "Economic surprises have been minimal over the past year, and there has been no reason for significant revision in expected future short-term interest rates," Mr. Poole said.
Jeffrey Lacker, president of the Federal Reserve Bank of Richmond, suggested on June 20 that there may be less uncertainty about inflation than in the past.
"It's important to keep in mind that the term premium shouldn't be expected to behave in the way it's behaved in postwar cycles in which inflation was unsteady," Mr. Lacker said. "The most likely explanation for the low rates," he said, is that "inflation is low and that inflation expectations are low."
Wall Street economists are as divided as Fed officials about the proper interpretation.
James Glassman, a senior economist at J.P. Morgan, contends that long-term interest rates reflect the deflationary effects of globalization. "If you think of this in economic terms, East Asia and Nafta have been annexed to the United States. It looks like an economy that has far more excess capacity. Overnight, decisions by the Chinese government are releasing huge numbers of Chinese laborers. That means more excess capacity and a longer time to get back to full employment."
By that interpretation, the Fed could stop raising short-term rates once they reach 3.75 percent. But others predict that the Fed will continue to worry about inflationary pressures, the United States' soaring level of foreign indebtedness and the dangers of a housing bubble.
Mr. Greenspan, asked by lawmakers to specify a "neutral" Fed funds rate - one that would try to neither speed nor slow the economy - has periodically remarked that people would know it when they saw it. But in his most recent testimony, he added a twist: people would know it because "we will observe a certain degree of balance which we have not seen before" in the economy.
Copyright 2005 The New York Times Company