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U.S.: A Short Cut to Lower Long-Term Rates


On the first day of the Federal Reserve's June 24-25 meeting, policymakers sat down to discuss the economic outlook in preparation for their semiannual report on monetary policy and economic forecast, due in mid-July. Almost certainly, the policymakers' projections were bolstered by gains in the financial markets this spring and improvement in the economic data. Then, on its second day of meeting, the policy committee seemed to ignore those better prospects and cut its overnight lending rate by a quarter-point, to 1%.

Why did the Fed cut rates? Normally, an improving outlook would cause the central bank to hold its fire, especially after it had already slashed its policy rate from 6.5% to 1.25% over the past 2 1/2 years, and in the face of some powerful fiscal stimulus when the tax cuts begin to kick in on July 1.

But these are hardly normal times. With inflation exceptionally low and recovery still not assured, the risk of overstimulating the economy is minimal. But the Fed has taken short-term interest rates about as low as they can go. Now, policymakers appear to be concentrating on a new tactic -- getting long-term interest rates down and keeping them there until the anemic recovery begins to show a little energy. The hope is that lower rates across the yield spectrum will provide a healthy dose of iron.

BEAR IN MIND, the bond market is the key to more accommodative financial conditions. The lift from low long rates is already evident in the ongoing housing boom. Not only have cheaper borrowing costs boosted home sales and new construction, but they have enabled millions of homeowners to refinance their mortgages.

Now, low bond yields must work their magic on the business sector. They will make stocks relatively more attractive, and low rates across the board make U.S. debt securities less appealing to foreigners. That keeps the dollar down, boosting international competitiveness for exports and lifting earnings from foreign operations. The crucial link between better financial conditions and a solid recovery will be a pickup in capital spending, which is heavily dependent on both growth in demand and financing costs.

Before late June, the Fed had managed the goal of lower long rates through words instead of overt policy actions, such as buying long-maturity Treasury bonds. The Fed's intent first became clear after its last meeting, on May 6, when policymakers warned of an "unwelcome substantial fall in inflation." Since then, simply talking publicly about the risks of deflation -- however small they may be -- crushed inflation expectations, a key component in long-term rates. The discussion convinced bond traders that the Fed would hold short-term rates down for many months to come.

But in recent weeks, bond investors have grown a little weary of the Fed's jawboning. In the week leading up to the latest meeting, long-term rates inched up, as economic data started to look firmer. Basically, the bond market was telling the Fed, "Talk is cheap. Put up or shut up." So on June 25, the Fed had to put its money where its mouth was. The alternative was to risk a sharp reversal in bond yields that could thwart the economy's chances to stage a strong recovery.

THE FED GAVE THE BOND MARKET most of what it was looking for. A survey by Bloomberg Financial Markets showed that one out of three Fed watchers expected a half-point cut. In fact, one policymaker, San Francisco Fed President Robert T. Parry, dissented from the rate decision, preferring a half-point cut. However, the Fed's improved outlook for growth apparently undermined the rationale for a larger cut.

Even so, the Fed's policy statement held out the hope of further policy easing. As it did in May, the Fed separated its outlook for economic growth from that for inflation. For growth, it said, "recent signs point to a firming in spending, markedly improved financial conditions, and labor and product markets that are stabilizing." Recently, Fed officials have seen improving trends in the leading indicators, retail sales, regional factory surveys, and consumer confidence (chart).

But the Fed repeated its May concern about the risk of deflation, and said that this concern is "likely to predominate for the foreseeable future." In effect, the Fed was hinting to the bond market that it was leaving the door open for further easing in case the risk of deflation rises. Indeed, after the cut, trading in federal-funds futures pointed to a growing belief that the Fed will cut rates again at its August meeting. But if the Fed's campaign to talk long rates lower produces stronger growth and pricing power, the June cut will be the last for this cycle.

SO FAR, THE FED'S SUCCESS on the long-rate front can be seen mostly in housing, where demand remains strong. New home sales in May jumped 12.5%, to a record 1.16-million annual rate (chart), while sales of existing homes edged up 1.2%, to a 5.9-million pace. In addition, lower rates over the past few months have generated a new burst of mortgage refinancings. When these new loans are closed over the next few weeks, consumers will reap the benefits of either taking cash out of their homes, lowering their payments, or shortening the maturity of their loans.

However, the strong influence of long rates on all facets of housing raises the question: Will a turnaround in the bond market cause the sector to collapse? The Fed doesn't seem ready to confront that risk just yet, but at some point it will have to. Eventually, long rates will rise, as they always do, as a result of a better outlook for the economy. Stronger growth will generate new jobs and fatter pay raises, and those benefits to the consumer sector will outweigh some of the drag from rising mortgage rates.

Even so, expect the higher borrowing costs to slow home sales and temper price gains somewhat. That's because buyers typically determine housing affordability by their monthly mortgage payments rather than the overall price of a house. Less demand will slow construction, or at least cause a shift to building cheaper homes, which will hold down housing's contribution to real gross domestic product growth. But this slowdown will occur just as other sectors in the economy, bolstered by the coming stimulus from tax cuts, begin to add to growth. As a result, a softer housing sector won't be a big drag on the economy.

But the real measure of the Fed's success at keeping long rates down will show up in a rebound in the business sector, where weakness in capital spending has been the chief factor holding back the recovery. The Fed knows that once business investment picks up, the economy will kick into a higher gear, and the risk of deflation will become a moot point. By James C. Cooper & Kathleen Madigan


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