Long-term bond yields are shockingly low despite the Fed’s best efforts to push them higher. Alan Greenspan calls it a “conundrum.” What does that mean? The Fed must fight inflation and recession at the same time, says John Mauldin, president of Millennium Wave Advisers.
The Fed is in an extraordinarily difficult position.
Some very distinguished observers believe it should stop tightening credit. Too much tightening, they say, and we risk recession.
But others think the Fed should keep raising short-term rates for the rest of the year. Too little tightening, according to this view, and we risk inflation.
Who’s right? Both are. So the Fed is trying to play it down the middle. It wants to see longer-term rates rise enough to slow surging U.S. home prices, but not enough to choke off the market. It wants to see rates low enough to help stimulate the economy if we are indeed going through a ‘soft patch.’
In short, the Fed is looking for the sweet spot. But where is it? Should the Fed funds rate be 3%, as it is now, or 3.5% or 4%?
It’s almost certain that the Fed’s Open Market Committee will raise rates another quarter point at its meeting later this month to 3.25%. That would be the Fed’s ninth quarter-point hike in about a year.
But should the Fed pause after this month’s meeting and see what happens to inflation and the economy? Or is it better to pre-emptively continue to raise rates and drive a stake in the heart of inflation?
Fed futures suggest Greenspan & Company will raise rates another 50 basis points after the June meeting to 3.75%. Meanwhile, the 10-year Treasury note is trading well below 4%. (It even briefly touched 3.82%.)
Last week’s payroll report, which showed the U.S. created a mere 78,000 jobs in May, was consistent with super-low yields. David Rosenberg, Merrill Lynch’s chief North American economist, suggests we could see a 10-year yield of 3.5%. Bill Gross, Pimco’s bond guru, suggests that the 10-year bond is going to 3%.
If they are right, and if the Fed does raise short-term rates to 3.75%, as the futures market suggests, we would have an inverted yield curve. That’s the relatively rare phenomenon in which the interest rates that investors receive on short-term notes is greater than the rate they receive on long-term bonds.
If that happens, it’s time to worry. In 1996, the New York Federal Reserve did a study on what indicators were the most reliable predictors of a recession. The only one of six indicators that was significantly reliable was an inverted yield curve.
Of course, the Fed could keep short-term rates shy of 3.75%. In a recent speech, newly appointed Dallas Fed Governor Richard Fisher suggested we are close to the end of the tightening cycle, and that’s one reason why interest rates on the long bond have tumbled.
‘We’ve gone through eight innings here, 25 basis points an inning,’ Fisher recently told The Wall Street Journal. He was referring to the eight quarter-percentage point rate hikes made by the Fed since it began hiking borrowing costs this time last year, raising the Fed funds rates from 1% to 3%. ‘The next meeting in June is the ninth inning,” Fisher said. “We may have to go into extra innings in this contest against inflation.’
Still, other Fed governors are suggesting that the ‘measured” rate increases need to continue.
Atlanta Fed President Jack Guynn said earlier this week that interest rates are too low to be considered ‘neutral” and might be over-stimulating the housing sector.
Meanwhile, Richard Berner of Morgan Stanley, among others, argues that inflation is not yet tamed. He says that the data clearly show that there are increased inflationary pressures. Unit labor costs are rising rapidly and productivity is slowing, which is something new. Such a trend suggests more inflation in the pipeline. The bond market will surely come around in time to understand this, he saysIf you hold that view, it would explain why Greenspan might think the bond market is a “conundrum.” If inflation is increasing, then long rates should be rising.
Whatever your position on Greenspan is, he has spent a career, and built his reputation, as an inflation fighter. Minutes from the FOMC meeting on 3 May released last week also showed that the Fed’s policy-setting committee was keenly aware that inflation pressures had picked up.
Historically, the Fed has tended to tighten for far longer and to a greater degree than what most observers at the time thought they would. They have been nothing if not consistent in their fight against inflation. Why would Greenspan back off in his fight against inflation in his last year as Fed chairman?
I think the Fed will come to see that the preponderance of risk is that raising rates chokes off the economic expansion. If inflation does become a problem at some later date, the Fed can always raise rates at that time. In fact, dealing with some future recession when inflation is higher than it is today would actually make it easier to deal with any potential deflation.
So, you raise rates at the June meeting, and then see what the data from July tells you at the August meeting. You change the language at the June meeting to let everyone know that any future interest rate hikes are now determined on a meeting-by-meeting basis. To use Fisher’s baseball analogy, you call a rain delay after the June meeting.
Will it work? No one knows. No one knows what the natural level of interest rates should be. No one knows how all the myriad influences on the economy will play out. And it is not altogether clear that, even if the Fed hits the ball on the sweet spot, that it will land at a safe place. When you’re hitting blind, all you can do is drive over the hill and hope for the best.
This is why I would argue that we should more clearly define the role of the Federal Reserve. If the Fed focused on steady growth of the money supply in line with GDP, and let the markets deal with the business cycle, we would have less of this uncertainty.
By John Maulin in FrontlineThoughts
You can get John Mauldin’s free weekly letter at www.2000wave.come. Or write him at john@frontlinethoughts.c