Magazine

Commentary: Interest Rates: Is the Fed Fretting Too Much?


By Rich Miller

As the tanking Treasury bond market sent interest rates soaring over the past month, Federal Reserve Chairman Alan Greenspan and his central bank colleagues have begun to work the worry beads. Small wonder. After falling to a low of 4.2% in early November, the yield on the benchmark 10-year Treasury note has now shot back up to 5%; on Dec. 5 alone, the 10-year note suffered its biggest rise in yields since January. The surprise jump has left central bankers fretting that their efforts to get the economy moving again would be stifled--and that they would have to keep cutting short-term rates willy-nilly in response.

Well, it's time to chill out. There's more good news than bad in the run-up in long-term rates. Bond yields had fallen so low partly due to fears of a deflationary meltdown of the economy post-September 11. As the fears dissipated, yields were sure to pop as investors moved money out of safe Treasury securities and into riskier assets such as stocks.

Of course, there's always a risk the markets will overdo it and push long-term interest rates too high, hurting the economy in the process. Mortgage rates, which now play off the Treasury's 10-year note, rose to an average of 7.02% at the end of November, their highest level since July and well above the low of 6.45% set earlier in the month. If mortgage rates rise much further, that could crimp the housing market, one of the economy's few bright spots.

Fortunately, though, the Fed is hardly powerless when it comes to influencing long-term rates. And the good news is bond yields are not being driven higher by fears of inflation. Rather, they're rising on growing expectations of an early, robust recovery next year. That in turn has investors worried the Fed will raise rates sharply next year.

But Fed officials think the market has got it wrong on both counts. They expect a more muted recovery starting in the middle of the year. And they think market expectations of 150 basis points or more of Fed tightening in 2002 are overblown. To the extent they can convince the market that its fears are overblown, that will help cap long-term rates.

POSITIVE SIGNS. On the whole, the bond market action over the past month should provide some comfort to the Fed. After the September 11 attacks, Greenspan grew worried investors would hunker down and shun risk, parking their money in safe Treasury securities. Those fears haven't been borne out. Indeed, as Treasury yields rose through much of November, junk-bond yields fell because investors were betting the Fed's monetary medicine and a big dose of fiscal stimulus would rapidly revive the economy and limit defaults. Investors poured some $1.8 billion into junk-bond mutual funds in November, according to Martin Fridson, high-yield strategist at Merrill Lynch & Co. That's up sharply from $1 billion in October.

In another sign of confidence, companies have sharply stepped up their issuance of corporate bonds. To clean up their balance sheets and raise money for future expansion, corporations tapped the bond market to the tune of $73 billion in October and $56 billion in November, according to Standard & Poor's Corp. That's good news for the economy, even if the higher supply of bonds pushed prices down and yields up.

Other technical factors, such as forced selling of interest-rate futures by beleaguered energy giant Enron Corp. and shifting hedging strategies by mortgage lenders like Fannie Mae, also played a role in the November run-up in bond yields. But as those factors have faded, they're no longer placing significant pressure on yields.

Fed officials are also doing their part to bring yields down. On Nov. 27, the normally hawkish Fed Governor Laurence H. Meyer triggered a big rally in the bond market when he said the economy still wasn't out of the woods. That sent a signal that the Fed is ready to cut rates at their next meeting on Dec. 11. The quick response--yields fell a quarter percentage point in just a few days--showed the Fed hasn't lost its touch with bond investors. The bottom line: Signs of a reviving economy mean long-term rates are unlikely to revisit their post-attack lows. But, provided the Fed plays the markets right, neither will rates set off on an upward tear that hurts the economy. Miller covers the Fed from Washington


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