Faced with the threat of a deflationary downturn in the summer of 2003, Federal Reserve Chairman Alan Greenspan and his central bank colleagues embarked on an unorthodox monetary strategy. For the first time ever, they provided investors with specific guidance on future monetary policy, saying interest rates would stay low for a "considerable period." As the economy recovered and the Fed raised rates in response, it continued to try to manage expectations so as to avoid upsetting the markets, saying it would tighten credit at a "measured" pace.
But what started out as a well-meaning attempt to give investors a clear sense of where monetary policy was headed has degenerated into a muddled message that has sown confusion in financial markets and helped fan fears of higher inflation among investors. That has raised questions inside and outside the Fed about whether the central bank's extraordinary strategy of mollycoddling the markets has done more harm than good. "In retrospect, there have been more negatives than positives," says former Fed official Lyle Gramley, now with the Stanford Washington Research Group financial advisory firm. The biggest fear: that the Fed's strategy of managing long-term interest rates has backfired, overheating the economy and setting the stage for a revival of inflation.
To be sure, it's hard to argue with the results so far. Since the summer of 2003, the economy has grown at a 4.5% annual clip. While inflation has picked up, it's still modest by historical standards. Excluding volatile food and energy costs, consumer prices rose at a year-over-year rate of 2.4% in February. Meanwhile, financial markets have avoided the sort of turbulence that often marked previous Fed credit-tightening campaigns.
That soothing scenario may be coming to an end. Spurred on by soaring energy prices and galloping consumer and business spending, expectations of inflation are rising in the financial markets. That has prompted worries that the Fed will need to raise interest rates more aggressively.
Indeed, such concerns sent stock prices skidding lower and bond yields soaring to their highest level in nine months on Mar. 22 after the Fed raised rates another quarter percentage point, to 2.75%. Uneasy investors ignored the Fed's declaration that it would continue to raise rates in tiny increments. Instead, they focused on the central bank's acknowledgment that inflationary pressures have picked up and marked up their expectations for coming hikes in the eurodollar and other interest-rate futures markets.
THE CARRY TRADE
When the Fed first started to provide the markets with specific guidance on its policy intentions, it had a simple aim: It wanted to steer the economy clear of the deflationary abyss by better aligning long-term interest rates with the short-term ones it controls. After all, it is long rates -- on everything from mortgages to corporate bonds -- that are far more important to the economy.
Besides, with short-term interest rates at a 45-year low of 1%, the Fed was running out of room to ease credit more on that score. So it tried to exert its influence over long-term rates, not by buying bonds in the market but by committing to an easy monetary policy for an extended period, says economist Louis Crandall of consultants Wrightson ICAP. And the strategy worked. Even as the economy recovered, long rates remained low, anchored by the Fed's pledge of cheap credit.
But the tactic began to run into problems as the economy gained steam and the Fed began raising short-term rates last summer. Rather than rising in tandem with the Fed's actions, long-term rates fell. Indeed, it wasn't until their rise on Mar. 22 that bond yields were back to about where they were when the Fed embarked on its campaign of rate hikes in June, 2004. "The bond market has not done the Fed's work for it," says former Fed Vice-Chairman and current Princeton University professor Alan S. Blinder. The persistently low level of long-term rates has helped propel the economy forward, fanning fears of faster inflation ahead.
So why did bond yields stay so low? In part, it's because of the Fed's own policies. Reassured by the central bank's promise of "measured" rate hikes, speculators piled into what is called the carry trade: They borrowed money at low short-term rates, then turned around and invested that in higher-yielding bonds. That bond buying helped hold down long-term rates. Normally, such a strategy would be considered risky at a time of rising short-term rates. But hedge funds and other speculators felt they could get away with it because of the Fed's clear-cut policy of gradual rate hikes.
The controversy over how clear the Fed should be about its intentions harkens back to the mid-1970s, when monetarist Milton Friedman argued that a predictable policy path was the best way to control inflation and avoid meddling in the economy by well-meaning, yet inept, central bankers seeking to control output.
Fed officials always recognized that special circumstances enabled them to embark on their hands-on market strategy 1 1/2 years ago. Inflation was low -- uncomfortably so, in the minds of many at the Fed. Productivity was exceptionally strong. And although the economy was recovering, the upswing looked fragile.
The question now is whether the Fed stuck with that strategy for too long as the economic forces shifted to higher inflation, sturdier growth, and slower productivity. If it did, then the markets and the economy could be in for some bumpy times ahead as Greenspan & Co. try to cap the inflationary pressures they have unleashed.
By Rich Miller in Washington