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August 09, 2005
Ho-Hum, Now What's To Come?
Analysts greeted the FOMC Statement with a great big yawn. I cannot recall a time when the market reaction was so imperceptible.
In addition to noting pgl's disappointment, I take note of an earlier post from Professor Polley, in which makes a point that deserves some consideration:
What strikes me as odd, and a bit worrisome, is the idea that the economy has to hit a "soft patch" (for lack of a better word) to give the Fed the signal to stop raising rates.
A “neutral” monetary policy—one that avoids both inflationary and disinflationary pressures (as well as both artificial stimulus and unwarranted restraint on the pace of real economic activity)—requires that the funds rate target adjust to the evolving demand in credit markets as consumption, investment, and employment expand in anticipation of continued growth...
Now, as the economy strengthens and investment and employment growth recover, the neutral setting of the funds rate is moving up. The distance it will go depends on myriad factors, most (if not all) of which will only be revealed in time (perhaps at a measured pace).
Just prior to the June FOMC meeting, the spread between 10-year Treasury yields and the federal funds rate was about 100 basis points. After today's funds rate target change, and at the close of the market this afternoon, the spread is about 90 basis points. To me, that does not spell a lot of tightening with this move.
Now James Hamilton would argue, I think, that I should not take much comfort in this:
... over the last two months, the trend in long yields has reversed, and long-term rates have come back up significantly. However, even if we only focus on the last two months, the rise in long rates is less than the rise in short rates. It's also interesting to note that inflation-indexed Treasuries have gone up together with the 10-year nominal yield, suggesting pretty strongly that it's not inflation fears that have contributed to the increases in the long rate, at least up to this point. Instead it looks much more like the market has come to expect ongoing rate hikes, driving the 10-year rate up through expectations of a higher fed funds rate over the next few years.
I fully agree that there is scant evidence of any run-up in inflation expectations that would account for the rise in long-run rates. But I'm not sure at all that I buy into the conclusion that all we are seeing is the expectation of further funds rate increases being built into the long rate. Long-term real interest rates have something of a life of their own. To be sure, arbitrage requires that the expected path of short-term rates be consistent with yields on longer-lived bonds, with appropriate adjustment for term premia, etc., etc. But longer-term real rates are driven in large measure by rel economic activity -- and that is indeed picking up.
So, I'm not ready to conclude that the policy stance has changed much since early summer. That does, of course, leave William's other very good question unanswered:
Though I don't think another one or two quarter point moves will throw us into a tailspin, I worry that the FOMC has painted themselves into a corner linguistically. How are they going to break it to the market that the rate hikes are about to pause?
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