Tepid growth, stable interest rates

The U.S. economy has slowed down noticeably in recent quarters. During the previous three quarters, economic growth has averaged 2.25 percent. Growth during the first quarter of 2007 may prove to be even more tepid. But don’t expect the Federal Reserve to lower its short-term target interest rate tomorrow. The Fed’s policy committee will almost certainly maintain the federal-funds rate at 5.25 percent.

The fed-funds rate hasn’t budged since June, when the Fed lifted it by a quarter percentage point for the 17th time in two years. The central bank steadily raised the rate from 1 percent in June 2004 to 5.25 percent in June 2006.

It turns out that the Fed’s policy committee was right in January when it warned that “some inflation risks remain.” The overall consumer price level has been rising at an annual rate of 4 percent during the December-February period. That represents a significant acceleration compared to the last 12 months, when overall consumer prices increased by 2.4 percent. Moreover, during the same December-February period, core consumer prices, which exclude food and energy, have been rising at an annual rate of 2.6 percent. That’s comfortably above Federal Reserve Chairman Ben Bernanke’s “comfort zone” of 1 percent to 2 percent for core price inflation. And the 12-month rate of increase in core consumer prices is even higher: 2.7 percent. Meanwhile, core prices for finished goods at the wholesale level have been rising at an annual rate of nearly 5 percent over the previous four months.

The behavior of long-term interest rates, such as the yield on the 10-year Treasury note, has been quite interesting during the last three years. Unlike short-term interest rates, which the Fed can control, long-term rates are essentially determined by the global bond market. During May 2004, the month before the Fed began raising short-term interest rates, the yield on the 10-year Treasury note averaged 4.72 percent. Keep that rate in mind.

Now, as noted above, the Fed raised the interest rate from 1 percent in June 2004 to 5.25 percent in June 2006 — and has kept it there ever since. The Fed exerts direct control over the fed-funds rate through its ability to inject or withdraw reserves (i.e., money) throughout the banking system. When the Fed wants to raise the fed-funds rate, it sells bonds and thereby reduces the money (i.e., the reserves) that banks have available to lend to one another. With fewer reserves available, their price (the fed-funds rate) rises.

What has happened to the yield on the 10-year Treasury note? Interestingly, that yield averaged 4.72 percent last month, the precise average interest rate that prevailed in May 2004, just before the Fed began raising short-term rates. Despite budget deficits and declining personal savings in the United States, a soaring global savings glut has been sufficient to overwhelm these domestic trends and keep U.S. long-term interest rates (both nominal and inflation-adjusted) well below the levels that would otherwise prevail. As short-term rates have risen since mid-2004, the behavior of long-term rates has been the really big story.