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Steady Growth, Low Inflation, Puzzling Bond Market

Author: Roger M. Kubarych
February 17, 2005
Council on Foreign Relations


The bottom line of Fed Chairman Greenspan’s semi-annual monetary policy report to Congress yesterday might be paraphrased along the following lines: “The US economy is strong and stable and we, the Fed, predict with some confidence that this combination will last, at least into 2007. But we are puzzled by what has been happening in the financial markets, in particular the highly unusual decline in bond yields in the United States and elsewhere.” In fact, the Fed has barely changed any of the economic forecasts for 2005 that it made in the previous report to Congress last July, having accurately predicted the actual outcome for 2004.



In Greenspan’s own words: “Over the past two decades, the industrial world has fended off two severe stock market corrections, a major financial crisis in developing nations, corporate scandals, and, of course, the tragedy of September 11, 2001. Yet overall economic activity experienced only modest difficulties. In the United States, only five quarters in the past twenty years exhibited declines in GDP, and those declines were small. Thus, it is not altogether unexpected or irrational that participants in the world marketplace would project more of the same going forward.” He made a stab at warning against complacency, reminding his Congressional (and market) audience that after long periods of stability people are “prone to excess.” But it was hardly a ringing alarm, and he discussed no policy actions that might be needed to rein in whatever excesses may now be building.

Indeed, Greenspan was hard pressed to cite any immediate threats to the business expansion. To be sure, he noted that business executives remain cautious. Notwithstanding the advance of capital investment in the past year, capital expenditures have “lagged the exceptional rise in profits and internal cash flow. This is most unusual; it took a deep recession to produce the last such configuration in 1975.” Hiring decisions have also been more cautious than in many past business cycles. He didn’t mention the tremendous competition from imports that has been plaguing US manufacturing but that is obviously responsible for much of the hesitancy he cites. But he did mention “concerns of business executives about potential legal liabilities rather than a fundamentally different assessment of macroeconomic risks.” That is a theme that President Bush pushed in his State of the Union message and is behind his proposals for tort reform.

Instead, Greenspan called attention to some familiar longer-term problems – the low domestic savings, the accompanying large current-account deficit, and the need to restore fiscal discipline and deal with Social Security and medical care entitlements. But he spoke with eloquence and conviction about the issue of rising income inequality in the United States: “In a democratic society, such a stark bifurcation of wealth and income trends among large segments of the population can fuel resentment and political polarization. These social developments can lead to political clashes and misguided economic policies that work to the detriment of the economy and society as a whole.” He highlighted the critical role of the American educational system in equipping workers with the necessary skills to compete in a more globalized economy, a theme that former Treasury Secretary Rubin also emphasized in a lecture to the Institute for International Economics in Washington the day before. As Greenspan put it: “For the past twenty years, the supply of skilled, particularly highly skilled, workers has failed to keep up with a persistent rise in the demand for such skills. Conversely, the demand for lesser-skilled workers has declined, especially in response to growing international competition. The failure of our society to enhance the skills of a significant segment of our workforce has left a disproportionate share with lesser skills. The effect, of course, is to widen the wage gap between the skilled and the lesser skilled.” Incidentally, he didn’t note that the Bush administration’s FY 2006 budget calls for cuts in a variety of education programs designed to address that problem.

One of the most remarkable sections of the Chairman’s testimony – and a significant departure from past presentations – was his extensive, technical discussion on the puzzle of why the US bond market has strengthened in price, and produced lower yields, at the same time that the Federal Reserve has been raising short-term interest rates. Those lower bond yields translated into lower mortgage interest rates, which has had the effect of perpetuating the boom in housing market activity and home prices. That has added to household wealth and thus given an added lift to consumable resources. In other words, it has offset at least part of the restrictive effect that the Fed had sought through its monetary tightening.

Why does the Fed think this has happened? Greenspan cites some technical factors, such as purchases of long-maturity securities by mortgage portfolio managers as the durations of those portfolios unexpectedly shortened. He cites bond market expectations of eventual slowing in economic growth but discounts that interpretation because it “does not mesh seamlessly with the rise in stock prices and the narrowing of credit spreads observed over the same interval.” He cites the presence of large-scale foreign central bank purchases of US Government securities with dollars acquired in the foreign currency markets to keep their currencies from appreciating but notes that other bond markets (he mentions German Bunds specifically) have also seen lower yields. He mentions the secular decline in world inflation associated with the integration of China and India in the world economy but notes that it is real bond yields that have declined, not inflationary expectations per se.

So he effectively gives up: “None of this is new and hence it is difficult to attribute the long-term interest rate declines of the last nine months to glacially increasing globalization. For the moment, the broadly unanticipated behavior of world bond markets remains a conundrum. Bond price movements may be a short-term aberration, but it will be some time before we are able to better judge the forces underlying recent experience.”

The implication is fairly clear: the longer the bond market neutralizes Fed tightening, the higher the Fed funds rate will need to go up in order to meet the Fed’s objective of moderating the growth in domestic demand. The Fed is not overtly encouraging a sell-off in the bond market. But a reader is left with the impression that the central bank would not be terribly disappointed if one were to occur – and in the first 24 hours after the testimony it has been getting that unexpressed wish.

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