The Fed Signals More to Come

Very little is ever obvious in commentary by Federal Reserve Chairman Alan Greenspan, and that’s by design: He likes to keep his options open.

But there were two pretty solid take-aways from speeches Greenspan gave last week.

One is that the Fed isn’t worried that the economy is on a precipice.

And the other, which follows from the first, is that the central bank isn’t nearly finished raising short-term interest rates.

Addressing a financial conference in China via satellite and, later in the week, members of Congress’ Joint Economic Committee, Greenspan was asked in both venues whether he was worried that long-term interest rates have fallen over the last year even as the Fed has raised its key short-term rate eight times, to 3% from 1%.

Why should he be concerned? Because historically, declining long-term rates in the face of rising short-term rates have meant that investors expected the economy to slow markedly.

That used to be the message in such interest rate divergences, Greenspan said, which made it a “credible notion.� But this time, he said, things very well might be different.

In the parlance of Wall Street, an “inverted yield curve� occurs when longer-term rates are below shorter-term rates.

We aren’t there yet, but we’re getting close: The annualized yield on 10-year Treasury notes, 4.05% as of Friday, is down from 4.87% a year ago and is just 0.36 point above the 3.69% yield on two-year T-notes. A year ago, the yield difference between those securities was 2.07 points.

If an actual inversion should happen, Greenspan said, it wouldn’t automatically trouble the Fed and thus shouldn’t automatically trouble anyone else.

In his unique brand of English, here’s what he told Congress: “I would hesitate to read into the actual downward tilt of the yield curve as meaning necessarily as it invariably meant 30 or 40 years ago.�

Anyone who wants to believe that the split performance of interest rates is in fact sending the same economic message as always -- and that Greenspan is whistling past the graveyard -- can cite a previous “new era� pronouncement by the chairman. It was a speech he gave the same fateful week in March 2000 that the technology-stock mania was peaking, as measured by the Nasdaq composite index.

The gist of that address in Boston was not, “Look out below -- tech stocks are absurdly overvalued.�

Instead, Greenspan lauded the economic performance of the late 1990s and “what is evidently the source of this spectacular performance: the revolution in information technology.�

Nasdaq then, 5,048. Nasdaq now, 2,063.

Back to interest rates: To think it through, if the economy isn’t slowing, why are people so eager to lock in long-term bond yields -- not just in the U.S. but across much of the globe?

Greenspan wasn’t embarrassed to say he didn’t know. He said he wasn’t satisfied with any of the explanations that have been well-discussed on Wall Street in the last year, including that aging populations in the U.S., Europe and Japan are gravitating toward more conservative securities like bonds; that Asian foreign central banks are recycling their trade-surplus dollars into bonds; and that a general glut in savings worldwide means a lot of money is looking for a home.

Could it be, someone at the congressional hearing asked him, that bond investors are showing they believe that the Fed already has vanquished inflation with one year of credit-tightening? (After all, you wouldn’t buy a 10-year Treasury note yielding 4.05% a year if you figured the annualized inflation rate would soon top 4% and stay there a while, in effect consuming all of your return.)

“We’d like to believe that,� Greenspan said. “But the problem with it is that it doesn’t give us any information that is useful.

“If we said, ‘That’s true,’ it doesn’t tell us what to do.�

Some economists believe Greenspan and his peers at the Fed know exactly what they have to do, which is to keep raising their benchmark short-term rate to 4%, maybe even 5%, by early in 2006.

The chairman’s comments last week “make clear that the tightening process isn’t yet close to over,� said Bill Dudley, economist at Goldman Sachs & Co. in New York.

There are good arguments that the Fed is, to a large degree, now trapped in rate-raising mode.

The trap has been partly set by the bond market, with Greenspan’s help (as he blesses falling long-term yields). Lower bond yields mean lower mortgage rates as well, stoking the one part of the economy that surely doesn’t need it.

The Fed already stands accused of creating a housing bubble; who knows how low mortgage rates could drop if the Fed stopped raising short-term rates at this point, giving bond speculators more reason to pile on.

Indeed, Greenspan’s comments on the yield curve could be viewed as providing cover for more rate increases. If the economy will be fine even if short-term rates are above long-term rates, what’s the harm if the Fed keeps going?

Joe Carson, an economist at Alliance Capital Management in New York, asserts that money still is very loose after eight Fed rate hikes, which is why U.S. consumers haven’t stopped spending and economic growth remains on a strong pace, in his view.

“Have you ever seen the consumer stop buying when you give them easy credit?� Carson asks.

A simple, fundamental reason the Fed should keep tightening credit is that inflation pressures are building, the bond market’s apparently sanguine view notwithstanding.

The overall consumer price index, including energy costs, in April was up 3.5% from a year earlier. Some people may want to believe that high energy costs are transitory, but oil is back above $50 a barrel again.

What’s more, the government’s gauge of unit labor costs, which measures the cost of labor to produce a given unit of goods, rose at a 3.3% annual rate in the first quarter, far faster than expected.

If the Fed’s primary job is to maintain vigilance against rising inflation, what do those numbers say? Ian Sheperdson, chief U.S. economist at High Frequency Economics in Valhalla, N.Y., believes the inflation trends leave Greenspan with “very little room for maneuver� -- meaning, the credit-tightening process must go on.

Finally, the Fed has this excuse to keep raising its key rate: Somewhere out there lurks a major financial disaster (think: hedge funds) or a terrorist attack or some other calamity that could scare the daylights out of consumers and businesses.

If and when a bad thing happens, if it’s bad enough, people naturally will look to the Fed to do something. Cutting interest rates to 2% from 3% wouldn’t have the same impact as cutting to 2% from, say, 4.5%. The Fed needs more leeway to be effective in the next calamity, and if the economy is on “reasonably firm footing,� as Greenspan told Congress, then higher short-term interest rates shouldn’t topple it into recession.

Perhaps the bond market, in its sometime wisdom, knows all of this. Perhaps things really aren’t so different this time, after all -- and long-term bond yields are falling because investors sense that the Fed has a lot further to go in raising short-term rates, which will produce slower economic growth in 2006, lower inflation, and another downward cycle in interest rates.

If, instead, the economy surges and bond investors find they have made a big mistake locking in current rates -- thinking the yield curve was signaling a slowdown -- Greenspan will at least be able to say: I told you I didn’t buy it.

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Tom Petruno can be reached at [email protected]. For recent columns on the Web, visit www.latimes.com/petruno.