- The Washington Times - Saturday, June 28, 2003

Even by the standards set by a man known to move markets merely by raising an eyebrow or changing the inflection of his voice, Federal Reserve Chairman Alan Greenspan’s impact on the bond market following the May 6 meeting of the Fed’s monetary-policy committee was stunning to behold. Unfortunately, by deciding June 25 to reduce its overnight target rate by only a quarter-percentage point — rather than by the half-percentage point markets had anticipated — the Fed may have inadvertently stalled a bond market rally dead in its tracks.

When the Fed declined to reduce short-term interest rates May 6, it issued an extraordinary statement declaring that “the probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation from its already low level.” Coinciding with the Fed’s determination that “the balance of risks to achieving its goals [of sustainable growth and price stability] is weighted toward weakness over the foreseeable future,” its May 6 statement sent two clear signals to the financial markets. First, the Fed was likely to ease monetary policy in the near future by reducing its targeted overnight rate, which was already at a 42-year low of 1.25 percent. Second, short-term interest rates were unlikely to rise for quite some time, even if the economy rebounded in the near term.

Now, while the Fed can exercise a great deal of control over short-term interest rates, it is the bond market that determines long-term rates. Thus, while the Fed lowered the federal funds rate throughout 2001 from 6.5 percent in January to 1.75 percent in December, the rate on 10-year Treasury bonds actually increased from 5.10 percent to 5.14 percent over the same period. The rate on 30-year Treasury bonds also increased. Long-term rates eventually began to decline in mid-2002.

The Fed, of course, can influence inflationary expectations, as it does whenever it ratchets down the inflation rate. But the Fed’s May 6 statement by itself lowered long-run inflation expectations. Over the next 50 days, the 10-year Treasury bond rate plummeted from 3.89 percent on May 5 to 3.25 percent last Tuesday. The 30-year bond rate fell from 4.80 percent to 4.33 percent. In other words, long-term Treasury rates went south in a big way on the force of the Fed’s extraordinary May 6 statement. Mortgage rates plunged as well, setting off yet another bonanza of refinancing, which has played such an indispensable role in maintaining consumer spending levels.

When the Fed failed to deliver the expected half-percentage point rate cut last week, however, the bond market reacted negatively, sending long-term rates up three days in a row. Citing Bianco Research LLC, a financial research firm, the Wall Street Journal reported that bond prices, which move in the opposite direction of the yield, experienced their biggest drop last week after any monetary-policy easing since 1985. Admittedly, it is still too early to tell whether the helpful bond-market rally has ended. But it is safe to say that a half-percentage point cut last week would have been more helpful than the Fed’s quarter-point cut in stimulating the economy and fighting deflationary pressures.

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