Thursday, February 10, 2005

What does the future hold for US interest rates?

An important question, indeed, for ultra-low US interest rates are the bubble fuel behind comparatively robust US economic growth these last two years. They are sustaining the US federal government's borrowing binge as well as the US housing market, which in turn have been sustaining the US consumer, which in turn has been sustaining the export-dependent economies of East Asia and Europe as well as generating an unsustainable current account deficit for 2004:IV well in excess of 6% of GDP.

The conventional wisdom for over a year has been that the Fed will keep raising the federal funds rate to the point of "neutrality," whatever that is. With US growth around 4% in 2004, one would think that neutrality was somewhere in that vicinity. Into the fray wades Atlanta Fed President Jack Guynn, himself quite practiced in the art of Fedspeak.
The Federal Reserve still has "got a ways to go" on raising interest rates but may need to change the language in its policy statement, Federal Reserve Bank of Atlanta President Jack Guynn is quoted as saying in an article in the Wall Street Journal online Wednesday.

Guynn also is quoted as saying the Fed may have to change the language of its statement "not too far down the road," and says the language change could include dropping the words "measured" and "accommodative."

The language change may come sooner or later, "and maybe sooner," Guynn is quoted as saying.

"You can imagine not too far down the road where some things in the statement aren't going to be appropriate," Guynn is quoted as saying. "And we need to decide how and when to change some of that wording." "If we stay on the path we're on and withdraw some of the accommodation we've had in place ... we'll be at a point it's not quite as clear how much more we need to do and how quickly we need to do it," said Guynn
Markets took this as a signal that the Fed was nearly finished with rate hikes.
"This is a dovish comment for Guynn," said James Glassman, senior economist at J.P. Morgan, noting Guynn had a reputation as an inflation hawk.
and
``For many months, many have thought that removal of the word `measured' would be a signal of more aggressive rate hikes,'' said Paul McCulley, a managing director at Newport Beach, California-based Pacific Investment Management Co., which runs the world's largest bond fund. ``The market is finally recognizing just the opposite.''
Yet when I first read this statement, I had exactly the opposite reaction. So, too, did the markets, at least initially. According to Bloomberg,
The dollar initially gained on Guynn's comments as some traders interpreted them to mean the Fed will opt for larger rate boosts going forward, expanding the U.S. rate advantage relative to Europe, said T.J. Marta, a currency strategist in New York at RBC Capital Markets, a unit of Canada's biggest bank.
I have to agree with Marta. If the Fed has "got a ways to go" and is considering dropping the words "measured" and "accomodative", if the Fed may "withdraw some of the accommodation", then how can one jump to the conclusion that the Fed is going to top off at 3.00%? Greenspan himself is even owning up to his role in blowing bubbles with low interest rates. It sounds like the Fed is trying to signal the market that 50 basis point hikes are more likely in the future, and that 3% is nowhere near the ceiling.

And yet what did the markets do? They pulled the 10-year down under 4% for the first time since March 2004 (excepting a one-day dip to 3.99% in October). The 30-year FRM is down to 5.63% as well.

Without markedly higher real US interest rates, it is impossible for the US current account deficit to be brought under control. While Greenspan thinks the weakening dollar will now finally begin balancing US-Europe trade, there is no reason in the world to believe that US-Asian trade will begin balancing. And with oil staying above $40 for the foreseeable future, the US will continue to import and import and import. It wasn't that long ago, after all, that a $50bn monthly trade deficit was considered monstrous. Now it would be a welcomed as a kitten.

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