Now, though, Greenspan & Co. face the delicate task of nurturing that rally and the welcome fall in long-term interest rates that it has created. Bond prices fell sharply on June 25 after the Fed cut short-term interest rates by a quarter percentage point, less than the half-point reduction many investors had been hoping for. The sell-off--which drove the yield on the key 10-year Treasury note to 3.39% from 3.27% before the Fed's announcement--came even though the central bank held out the prospect of further cuts and ratcheted up its rhetoric on deflation. The danger of falling prices, the Fed said, would "predominate" for some time.
The Fed's decision was a difficult one. In a rare dissent, San Francisco Fed President Robert T. Parry voted in favor of a half-point cut. The remaining 11 members of the policy-making committee opted for the quarter point, even though some had suggested privately before the meeting that they were uneasy about reducing rates at all. In fact, with the economy showing signs of picking up, many private economists thought another cut was unnecessary. They argued that it could prove detrimental by pumping up incipient bubbles in bond, stock, and housing prices. Indeed, in its statement, the Fed acknowledged that the economy was looking better and that financial markets had "markedly improved."
But for the Fed, it's not enough that growth picks up to 3% or thereabouts in the second half from under 2% in the first. What the Fed wants is a sustained period of above-trend growth of 31/2% or more. Because productivity has stayed so strong, such supercharged growth is needed to restore shattered corporate confidence, bring down unemployment and, most important, dispel the danger of a deflationary downturn in prices and the economy.
As for the risks of bubbles, the last thing the Fed wants to do is repeat the mistake of the Bank of Japan. Wary of reinflating the stock market and property bubbles in Japan, the country's central bank held back for a time from aggressively pumping money into the economy. The result: an extended period of malaise and ultimately a dip into deflation.
That explains why the Fed isn't particularly worried by the risks of a bond bubble; if anything, it wants to cultivate a sky-high market. But keeping bond prices up isn't easy, as reaction to the quarter-point cut showed.
The reason: Much of the bond rally now is built on exaggerated fears of deflation and unrealistic hopes that the Fed will buoy the market by buying bonds. If those hopes and fears dissipate, look out below. "It looks a lot like the NASDAQ runup of the late 1990s and early 2000--dangerous," says Donald H. Straszheim, head of Straszheim Global Advisors Inc.
Although Greenspan & Co. have called the risks of a deflationary downturn remote, their constant harping on the subject has convinced many investors otherwise. "The markets are being inundated by this deflationary schtick," says William H. Gross, managing director of Pacific Investment Management Co., the world's largest bond-management firm. "At some point, that forces investors over the edge, forces them to buy bonds."
Investors also have been induced to jump into the market by hopes that the Fed itself will buy bonds to bring down long-term interest rates and keep deflation at bay. The trouble is, the more Fed officials have studied such a strategy, the more problems they've found with it. They fear that big bond buying by the Fed would just cause distortions in the market without having much economic impact.
So far, the Fed has done a masterful job in managing the bond market. The question now: Can it keep it up long enough to bring about the robust recovery everyone is hoping for? By Rich Miller