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August 07, 2005

Greg Ip Reads the Mind of the Fed

He writes:

WSJ.com - Fed Sees Bond Market Hampering Its Steps to Keep Inflation in Check: By GREG IP: WASHINGTON -- As the Federal Reserve prepares to raise short-term interest rates again next week, officials there increasingly believe the bond market, which sets long-term rates, is diluting their efforts to tighten credit and contain inflation. The result: The longer the bond market keeps long-term rates unusually low, the further the Fed is likely to raise the short-term rates.... This dynamic marks a striking break from the past when the Fed typically saw sharply higher bond yields as a reason to lift short-term rates further and low yields as a reason to worry about the economy.

Fed officials say future rate moves mostly depend on what data indicate about growth and inflation. With inflation low but the economy steadily using up unused capacity, officials plan to keep raising short-term rates to... a level... between 3% and 5% that neither stimulates nor restrains economic growth.... Some policy makers worry that bond yields are being kept in check by overly complacent investor sentiment which could rapidly dissipate, pushing up mortgage rates and shaking the housing market.... The Fed is expected to raise the short-term rate to 3.5% on Tuesday. Since June of last year, the Fed has raised the Fed funds rate target from a 46-year low of 1% to 3.25%.

Yet, over the same period, the yield on the benchmark 10-year Treasury bond has declined. It fell from 4.7% to below 4% a month ago, although its has bounced back up to 4.3%.... If "special factors," such as increased investor confidence that inflation will remain low, or purchases of bonds by foreign central banks, are the reason for low bond yields, "the federal-funds rate probably needs to be somewhat higher than would otherwise be appropriate," Ms. Yellen said. But if the market is anticipating hard economic times, "a somewhat easier policy may be appropriate," she said. In the past month, other key Fed policy makers have come to view special factors as the likelier explanation for low long-term rates than [beliefs in future] economic weakness.... Mr. Greenspan last month strongly suggested that he thought investors may be complacent. "Risk takers have been encouraged by a perceived increase in economic stability to reach out to more distant time horizons," he said. "Long periods of relative stability often engender unrealistic expectations of its permanence and, at times, may lead to financial excess and economic stress."...

Posted by DeLong at August 7, 2005 08:08 PM