Semi-Daily Journal

Interesting predictions. THis is what AG said,

"Allowing for known measurement biases, these inflation indexes have been in a neighborhood that corresponds to effective price stability--a long-held goal assigned to the Federal Reserve by the Congress. But we can pause at this achievement only for a moment, mindful that we face new challenges in maintaining price stability, specifically to prevent inflation from falling too low. This is one reason the FOMC has adopted a quite accommodative stance of policy. A very low inflation rate increases the risk that an adverse shock to the economy would be more difficult to counter effectively. Indeed, there is an especially pernicious, albeit remote, scenario in which inflation turns negative against a backdrop of weak aggregate demand, engendering a corrosive deflationary spiral. Until recently, this topic was often regarded as an academic curiosity. Indeed, a decade ago, most economists would have dismissed the possibility that a government issuing a fiat currency would ever produce too little inflation. However, the recent record in Japan has reopened serious discussion of this issue. To be sure, there are credible arguments that the Japanese experience is idiosyncratic. But there are important lessons to be learned, and it is incumbent on a central bank to anticipate any contingency, however remote, if significant economic costs could be associated with that contingency. The Federal Reserve has been studying how to provide policy stimulus should our primary tool of adjusting the target federal funds rate no longer be available. Indeed, the FOMC devoted considerable attention to this subject at its June meeting, examining potentially feasible policy alternatives. However, given the now highly stimulative stance of monetary and fiscal policy and well-anchored inflation expectations, the Committee concluded that economic fundamentals are such that situations requiring special policy actions are most unlikely to arise. Furthermore, with the target funds rate at 1 percent, substantial further conventional easings could be implemented if the FOMC judged such policy actions warranted."

Apparently, the Fed would go for further interest rate reductions.

On a personal note related to this issue, I have a lot of money in money market funds right now. What will these funds do if their expenses are higher than their income? Shouldn't the huge deficit start pushing up rates as it sucks up investment $$?

"The administration projected Tuesday that the federal deficit will climb to a record $455 billion this year and surge to $475 billion in 2004."

Wonder why....

First, find a fine low cost fund family as Vanguard or TIAA-CREF if you must use a money market.

Second, you would be far better off in a GNMA or short or intermediate term corporate or municipal bond fund than in a money market.

Households relying on interest income are finding the income falling. This is worrisome, but there will be no correcting the problem till interest rates turn up quite sharply. That may take quite some time.

If a household had held a long term corporate or municipal bond fund these past 3.5 years, then the household has a terrific increase in share price to cushion against the lower interest rates.

Notice that the interest rate on the 10 year treasury note has risen from 3.1 on June 13 to 3.9 today. Bonds are selling off sharply even though the federal funds rate was just lowered.

Unaccountably, some investors seemed still to think the Fed might engage in "unconventional" monetary policy operations, in the form of buying T-notes, right up to the point at which Greenspan let on that unconventional monetary policy actions were very unlikely. Combine that with his assurance that the Fed will maintain accomodative monetary policy as long as is necessary, and the trade of choice is a steepening of the curve. This is somewhat contrary to assurances heard from some market pundits that Greenspan would have to do something to reverse the rise in long rates. Asked if he was concerned about the rise in 10-year yields, Greenspan's answer was that the Fed expected it. The funds market was pricing in high odds of a 50 basis point ease, so doing only 25 meant an adjustment to the rest of the curve was likely. Implication? No big deal.

Interesting comments. Still, I am wondering whether bond investors are finally coming to understand how deep the deficit problem is. We will have a Federal deficit of 450 billion this years and more more more to come. Combined public and private saving in America should be zero or negative in the coming year, so there is far more pressure to come on the balance of payments. Bond investors must be careful.

Richard Murphy should consider maxing out in ibonds if he doesn't need the money for a couple of years. They are paying 4.66% and go up with inflation. Like all savings bonds, the principle is guaranteed. With the Fed trying to spur inflation, this is a good deal. Two caveats. There is an upper limit to how much ibonds you can buy. You must hold for 1 year minimum and lose one quarter's interest if you cash before 5 years. However, at 4.66% even if you cash after two years, you will beat rates on CDs or money markets.

Bakho

No way! I would buy a GNMA or intermediate corporate bond fund or high yield fund [Vanguard closed the high yield fund]. Otherwise, there are energy stocks and the like that have nice yields and are not too pricy.

bakho: I just looked at the Vanguard Inflation-adjusted bond fund and the yield is 1.42%. Where are you getting that 4.66% figure and where can I buy that bond?

Rich Murphy: I was just reading about this in the WSJ and the Japanese experience (low inflation) has apparently convinced the money-market fund management industry that they are going to have to reduce their funds. Investors will pull out their money if they are actually suffering negative returns. As common sense dictates.

About the steepening yield curve, it is good news no matter how you parse it. Either longer-term bonds are rising because of a stronger economy or the worry about long-term deflation is lessening. We should all be breathing a giant sigh of relief.

Buy them online or at a bank. They are a kind of savings bond but adjusted for inflation. More info at web site:

http://www.publicdebt.treas.gov/sav/sbiinvst.htm