Bond market raises doubts over Fed tactics

The Financial Times reports:

Bond market concerns about inflation are threatening to undermine the Federal Reserve’s ability to stimulate the US economy by ­aggressively cutting interest rates.

Since the Fed cut interest rates by 125 basis points in January long-term interest rates in the bond market have gone up, not down, working to slow the economy rather than to boost it.


The increase reflects investor concern about inflation and the belief that while rates might go very low in the short term, they might not stay there for very long.

This matters because in many respects the US economy is more sensitive to long-term interest rates than it is to the short-term rate the central bank directly controls.

Some economists see echoes of Alan Greenspan’s famous “conundrum” – the dilemma the Fed faced in 2004 and 2005 when it raised interest rates but long-term rates in the bond market did not budge.

They see what is happening today as a “reverse conundrum”.

Others say there is nothing particularly unusual about the gap between short-term and long-term rates widening at times of severe economic weakness.

However, all agree that the rise in long-term rates in recent weeks has weakened the impact of the January rate cuts.

In doing so, it has revived a longstanding debate about the effectiveness of monetary easing in the current economic environment.

Ever since the US central bank began to cut rates to mitigate the fall-out from the credit squeeze and housing crisis some economists said it was “pushing on a string” and would not have much impact.

They said interest rate cuts would not quell the downward spiral in housing – a classic asset price bust driven by unsustainable ­valuations.

Moreover, they argued that dislocations in credit markets and bank balance sheet strains would smother the impact of rate cuts.

Fed policymakers pushed back.

As Don Kohn, the vice-chairman, reiterated on Tuesday, they believed that rate cuts could mitigate the decline in the housing market and stimulate the broader economy by reducing borrowing costs, depreciating the dollar and supporting the prices of equities and other assets.

They also believe that rate cuts can moderate a widening in risk premiums by reducing the risk of a deep and protracted recession.

Looking over the period since the credit crisis broke in August, the Fed argument looks compelling. But since January the rise in long- term rates has weakened its case.

Since the Fed cut rates by 75 basis points on January 22 the yield on 30-year Treasury bonds – in effect, the 30- year risk-free interest rate – has gone up from 4.28 per cent to 4.67 per cent.

Largely as a result, the interest rate charged on 30- year fixed-rate mortgages has also risen sharply, from 5.49 per cent on January 21 to 6.09 per cent on Tuesday.

That rise in the cost of fixed-rate mortgages is putting renewed pressure on the housing market.

The Fed can't control the long end of the yield curve.Interest rates are going higher.Here's a look at the yield curve.