Back in February, when he first addressed the issue of stubbornly low bond yields, Federal Reserve Chairman Alan Greenspan called it a "conundrum." The mystery revolved around a simple question: Why were long-term interest rates falling even as the central bank was jacking up short-term rates? Back then, Greenspan ventured that the anomaly could be a temporary aberration and that in no time, bond yields might start acting in more traditional ways.
More than three months -- and two more rate hikes -- later, bond yields have once again been falling, surprising not only Greenspan but many market pros as well. Indeed, in early June, yields on 10-year Treasury securities fell sharply, to below 4%. Greenspan doesn't think the falling yields are a sign of slower growth ahead, as many in the market believe. But even with the economy powering ahead, he seems increasingly convinced low bond yields may be an enduring phenomenon, driven by a complex of international forces the Fed has yet to fully understand.
That shift has some at the Fed entertaining hitherto heretical thoughts. Maybe, they posit, ultralow interest rates aren't inflationary in a global economy awash with savings and dominated by cutthroat competition from China, India, and other developing nations. After all, it's bond-market investors who have traditionally been most sensitive to any whiff of inflation. If they're willing to accept low yields, that suggests the U.S. and the global economy may be far more inflation-resistant than once thought.
The notion has big implications for U.S. monetary policy as well. Ever since they began tightening credit in June of last year, Fed money mavens have sought to raise short-term rates gradually, to a so-called equilibrium level that perfectly calibrates the economy -- neither spurring inflation nor dampening growth. The bond market's behavior suggests the equilibrium rate may be much lower than in the past, some Fed officials speculate. If that's the case, then the central bank could be nearing the end of its credit-tightening campaign. In fact, the Fed might only need to raise rates a few more times -- starting with another quarter-percentage point hike at its meeting on June 29-30 -- before reaching the monetary sweet spot. "A lower level of rates than before may be consistent with the Fed achieving price stability," says Citigroup (C) economist Robert V. DiClemente.
To be sure, not everyone at the Fed is convinced of that case. Many of the bank's regional presidents seem more concerned than their Washington brethren that the low level of long-term interest rates could be building up inflationary pressures for a future explosion. And Greenspan has been wary of committing one way or the other to the new wave thinking. He told the Economic Club of New York on May 20 that the equilibrium rate was an "amorphous, complex" concept. "We'll know it when we see it," he said cryptically.
In some ways, the debate is reminiscent of one that took place at the Fed about 10 years ago. At that time, Greenspan & Co. were trying to divine whether dormant productivity growth was finally picking up in the U.S. and whether that meant the economy could grow faster than before without spurring inflation. Although the data was far from conclusive at the time, in the end Fed officials decided the economy could grow without sparking inflation and kept interest rates low, allowing the New Economy to blossom.
Now, it's a multifaceted set of global capital and trade flows that the Fed is trying to decipher. Part of the puzzle is that the U.S. isn't the only place where bond yields are low; they're down throughout much of the world. Indeed, in many countries, including Germany and Japan, they're even lower than in the U.S. In part, of course, that reflects the tepid outlook for growth in many foreign economies compared with the U.S. But everyone at the Fed seems to agree that something else is at work as well.
In struggling to figure out what's going on, Greenspan has focused on the increased integration of global financial markets and the stepped-up flow of capital worldwide. That has meant more of the world's savings can be invested across borders rather than being locked up in individual countries, as was the case with the former Soviet Union. As Greenspan tells it, investors' "home bias" -- their proclivity to keep their money in their own countries -- is diminishing, making a bigger pool of savings available internationally for investment in more profitable and productive ventures.
Some of Greenspan's colleagues at the Fed's board, including Vice-Chairman Roger W. Ferguson Jr. and outgoing Governor Ben S. Bernanke, have gone further. They argue that the world is awash with savings because of slumping demand for capital in the slow-growing economies of Europe and Japan and a buildup of currency reserves by China and other emerging Asian nations. Moreover, that global glut of savings is pushing down rates around the world.
At the same time, fundamental shifts in the global economy are exerting downward pressure on inflation worldwide. The breakup of the Soviet Union and the entry of China and India into the global trading system has led to a huge infusion of cheap goods, services, and labor into the world economy.
Yet from Greenspan's perspective, these shifts don't explain the decline in bond yields because they have been going on for a decade. He's also skeptical of some of the other arguments put forward to explain the puzzling fall in long-term rates. Yes, the markets could be signaling that economic weakness lies ahead -- the traditional reason for a sharp drop in rates. But in addressing an international bankers' meeting in Beijing via satellite on June 6, Greenspan pointed out that yields have fallen over the past year despite periodic signs of buoyancy in the global economy. Besides, the Fed is convinced that the U.S. economy remains on a path of solid growth and that recent weakness in manufacturing will prove temporary.
Some economists have argued that stepped-up buying of longer-term Treasuries and similar foreign securities by pension funds may have helped push down yields. Under pressure from regulators to shore up their finances, pension funds in the U.S. and Europe are putting more of their money into bonds. But Greenspan thinks that buying isn't large enough to account for the drop in yields.
In seeking to explain the low yields, other analysts have seized on the increased purchases of Treasuries by China, Japan, and other central banks seeking to recycle the stash of dollars they've bought in foreign-exchange interventions. But, Greenspan noted, that would not explain why long-term rates are down throughout the world, not just in the U.S.
In the end, the fall in bond yields remains a puzzle to the Fed chief. But it's gone on long enough to prod some at the central bank toward believing that the U.S. and world economies may have entered a new era of low interest rates.
By Rich Miller in Washington