Evans On The Economy -- Fed Holds The Line. But Then What?

Dec. 21, 2004
Higher interest rates are in the offing.

Around Washington, D.C., it's now an open secret that President George W. Bush and Federal Reserve Board Chairman Alan Greenspan struck a deal. Bush pre-appointed Greenspan to his fifth term in return for an unwritten pledge that the Fed would not raise the federal funds rate until after the 2004 election. What does this mean in terms of interest rates generally, the overall U.S. economy, and the rate of inflation? We know the bond markets didn't like the deal. Shortly after news of this deal began to circulate, the 10-year Treasury bond rate zoomed from 3.15% to 4.65%, an unprecedented gain following a Fed easing. In fact, something like this happened once before. Only it was the other major political party. You may recall that at the first Clinton State of the Union speech in 1993, the camera panned around the House chamber, and there was Alan Greenspan sitting right next to Hillary Clinton. Bond markets immediately took this as a sign that Alan was in cahoots with the Clintons, and over the rest of the year, the 30-year Treasury bond yield (the benchmark then) fell from 7.5% to 5.75%, even though inflation did not diminish, and real growth increased sharply during the year. Finally, at the end of the year, Greenspan decided the honeymoon was over, and he raised the funds rate from 3% to 6% the next year, catching many bond market traders completely off guard. As a result, the economic growth rate slowed from above 4% in 1994 to a measly 1.1% during the first half of 1995 before recovering again. Just like the rest of us, bond market investors learn from their mistakes, and they are in no mood to be caught off guard again. Thus, this time when the word went out that the Fed planned to hold the funds rate constant, bond prices fell through the floor. For the second half of this year, it is likely that real GDP will rise at a 3% to 4% annual rate, with the same performance continued in 2004. The "actual" rate of inflation depends on whether one uses the CPI or the implicit GDP deflator, but let's not quibble about that here. Over the next year and a half, I assume the core rate of inflation will be between 2% and 3%, a tad higher than recently. On that basis, nominal GDP is likely to rise about 6%. The unemployment rate will decline slowly but still remain well above its full-employment level of 4%. In that environment, the Federal funds rate would normally be about 5%, which means the 10-year Treasury bond yield would be about 6%. In mid-August, the Treasury bond yield was 4.5%, meaning half of the eventual gain had already taken place. Since the Federal funds rate is currently at 1%, it must rise a full four percentage points before returning to equilibrium. If the Fed fails to act in a timely fashion, inflationary expectations will once again flare up, and bond yields would rise even more than would be the case if the Fed were to act promptly. So for all of you out there banking on unusually low interest rates into the indefinite future, beware. The bond markets have already fired the initial warning shot, but further increases are on the horizon. And when interest rates finally do return to the 5%-to-6% range, it will be a whole different world for those who have come to rely on zero-interest rate financing and making ends meet by spending the increase in their home equity each year. Michael K. Evans is chief economist for American Economics Group, Washington, D.C., and president of the Evans Group, an economics consulting firm in Boca Raton, Fla.

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