Wednesday, February 16, 2005
Alan Greenspan is speaking to Congress today, and while most of the press and the bloggers will focus on his comments on Social Security, it's also noteworthy that he's taking some flak for running monetary policy with too much ease. For example, this article in the Economist last week shows a graph of real interest rates being negative far too long into the current business cycle expansion, and gravely intoning that "not content with running a lax monetary policy at home, America is also exporting its super-loose ways around the globe," creating a global asset price bubble.
This morning, John Lipskey and James Glassman of J.P. Morgan argue in the Wall Street Journal (subscribers only) that rates are just fine.
Can you see the problem with the Economist article? It is using CPI as the means to go from nominal Fed funds rates to real, whereas the Federal Reserve is using the deflator for personal consumption expenditures. (Links will take you to the data if you're interested.) Here's a picture of those two series' inflation rates (expressed as 12-month or four-quarter changes in the indices.)
Worrisome explanations are offered for the bond market's stubborn equanimity. Asian central banks, hedge funds, carry trades and mortgage-market shenanigans all have been proffered as evidence that low bond yields camouflage future travails. Inevitably, skeptics conjure up the specter of asset "bubbles." Can bond markets be aping 1999-2000, when the Nasdaq was stepping up to a spectacular swan dive?
Perhaps current low bond yields don't require such complicated and conspiratorial explanations. After all, Treasury bond yields, more than anything else, reflect the outlook for inflation. Strikingly, Federal Reserve officials by 2003 began describing the U.S. economy as operating within a "zone of price stability." And subsequent Fed policy moves have been consistent with keeping the economy "in the zone."
In fact, year on year increases in core inflation -- as measured by the Fed's preferred Personal Consumption Expenditure (PCE) price index -- have remained mainly within a 1% to 2% range since 1996. In late 2003, deflation worries dominated, as the core PCE flirted briefly with sub-1% increases. Amazingly, the indirect impact of last year's oil price surge only pushed this inflation measure back to the current 1.5%, just in the middle of its post-1996 range. Since mid-2004, core inflation's annualized pace has slowed back to the low end of the range.
The difference is 0.9% for the fourth quarter of 2004, which means that the Economist's graph is understating the real Fed funds rate by the same amount.
The last raise in the Fed funds rate to 2.5% moves that blue line back to about zero. If the current prices for Fed funds futures contracts for December '05 are to be believed, the real rate would move to about 1% if PCE inflation stays where it is. If oil prices ameliorate and the exchange rate starts to turn around, I'd expect PCE inflation for 2005 closer to 2% and a resulting real interest rate of 1.5%. That would be slightly accommodative, but not worthy of a tongue-lashing from the Economist.