Saturday, November 24, 2001

Federal Reserve Chairman Alan Greenspan, when asked by congressional leaders what they should do to help stimulate the economy, quickly responded: First, do no harm.
Political leaders could send long-term rates including 30-year mortgage rates soaring if, in responding to war and recession, they eliminate the budget surpluses and usher in another era of deficits.
“While there is an obviously very strongly desired sense to move rapidly, it’s far more important to be right than quick,” Mr. Greenspan said as he consulted with members of Congress in the weeks after the September 11 terrorist attacks.
Long-term rates have resisted the Fed’s aggressive rate-cutting efforts this year, even as the short-term interest rates most closely controlled by the central bank, such as the prime lending rate, have tracked the Fed’s dramatic reductions totaling 4.5 percentage points.
That’s partly because investors in the bond market, who collectively determine the level of long-term rates, have been wary that Congress is moving toward dissipating the surpluses, first by enacting a $1.35 trillion tax-cut bill and then by approving dramatically higher spending in the wake of the attacks to fund reconstruction, security and the war against terrorism.
Congress also is considering a $100 billion economic-stimulus package that, by design, will eliminate the surpluses and create deficits this year and next in an effort to revive the economy. The federal surplus hit a record of $237 billion in fiscal 2000, but last year’s surplus had shrunk to $127 billion before recession set in as a result of the tax cuts and yearlong economic slowdown.
Investors doubt pledges by political leaders that they will quickly restore the surpluses after the economic danger is over. Skeptics note that, in the few weeks since the surpluses were declared fair game, both parties have been trying to push through their political wish lists of spending increases and tax cuts. In the 1980s, they compromised by approving both, and the deficit soared.
Fed officials have been watching the budget feast on Capitol Hill with apprehension. Mr. Greenspan helped unleash the spending spree in the weeks after the attacks by endorsing both the $45 billion that Congress immediately approved for reconstruction, defense and airline rescue, and another $50 billion of carefully crafted stimulus measures to bolster the economy. Political leaders quickly doubled the original proposals in a bidding war.
“One of the risks here is that policy-makers pass a very large package just as the economy is recovering,” too late to help the economy and instead causing harm by driving up long-term interest rates, said Richard Berner, chief economist with Morgan Stanley Dean Witter, voicing the fears of investors and Fed officials.
“Whatever we sign off on today will have long-term consequences, and we’re already worried about it,” said Diane Swonk, chief economist with Bank One, noting that Congress does not appear to be making the budgetary trade-offs needed to avoid chronic deficits. Economists note that the list of spending “needs” outside of those already approved by Congress from bioterrorism to infrastructure reinforcement seems to grow by the day.
“Long-term interest rates pack a much bigger punch and impact growth more than short-term rates,” which is why the Fed is worried, said Sung Won Sohn, chief economist with Wells Fargo & Co.
Through its influence over the bond market, Congress affects not only 30-year mortgage rates, but also the rates on corporate bonds, which for issuers in financial straits have risen lately despite the Fed’s actions.
Recent Fed and Treasury actions suggest that both agencies are trying strenuously to draw down long-term rates to keep them from stifling a recovery. A surprise decision by the Treasury last month to stop selling 30-year bonds temporarily drove mortgage rates to a new 30-year low of 6.45 percent before the average rate bounced back up to 6.75 percent this week.
The specter of a return to deficits puts pressure on long-term rates because it means the government will have to issue more debt in the future to finance the deficits. Only six months ago, Congress appeared to be on track to keep piling up surpluses, enabling the country to pay off most of the $3.3 trillion public debt within this decade. Now that possibility appears to be remote.
Another reason long-term rates have not declined further this year is they already had dropped to 30-year lows in 1998 after the Asian financial crisis sent one-third of the world economy into recession and drew the U.S. inflation rate to a 12-year low of 1.6 percent. Rates shot back up again during the 1999-2000 economic boom, but declined at the end of last year as the economic slowdown set in and were at historically low levels even before the Fed began cutting interest rates.
Other credit markets have taken their cues from the Fed this year to varying degrees. Banks have eased personal and small-business lending rates, although credit-card rates remain stubbornly high, averaging close to 15 percent despite the Fed’s prodding.
Auto-financing companies, on the other hand, have slashed some of their loan rates to zero. Their effort to unload large inventories of cars met with a smashing success that has inspired imitators. IBM Corp. announced last week that it will offer some of its business computers with zero-interest financing.
The rates on 30-year mortgages are closely linked to the rates on 10-year Treasury bonds. While the bond market responds to short-term dips in the economy and inflation, it is most concerned about where inflation and interest rates are headed in the long run after the current economic difficulties are over.
Because of the focus on prices, long-term rates reflect investors’ collective judgment on whether the Fed has been successful at controlling inflation. They have remained elevated this year partly because investors doubt that the Fed will make much further progress against inflation after achieving the 1998 low. Inflation, as measured by the U.S. Consumer Price Index, last year jumped to 3.4 percent and this year is averaging around 2.5 percent.
Some economists say inflation could drop back toward 1 percent next year, but only if the recession proves longer and deeper than most expect. On the other hand, many investors believe the Fed’s leniency in cutting rates close to the rate of inflation this year risks causing a spike in inflation when the economy picks up again next year.
“The combination of larger deficits and concerns about higher inflation once the economy does turn around will push bond rates higher as soon as the first signs of recovery are visible,” said Michael K. Evans of the American Economics Group.

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