April 6 (Bloomberg) -- The first thing I become aware of is a quickening in my heart rate. My palms start to sweat. I get a sick feeling in the pit of my stomach. I feel agitated and distracted.

Then it hits me. I'm having my normal sympathetic nervous system reaction to Long Rate Loop De Loop -- you know, the ``analysis'' suggesting the economy is locked in a never-ending cycle driven by long rates: Rising long rates are going to slow the economy, which will lower long rates and encourage stronger growth, which will raise long rates, and so on, and so on.

Then I hear the voice of my late friend and economist Bob Laurent, saying what he always said in response to such nonsense: If long-term rates move the economy, why does every central bank in the world target short-term rates?

More importantly, why do investors and journalists devote so many hours and column inches trying to divine what the Federal Reserve will do with the overnight rate if what really matters is long-term rates?

It's a good question. Bob always said there was no reason the central bank couldn't buy and sell long-term bonds if policy makers thought that was the price, or interest rate, that mattered. If the long rate really influences the economy, encouraging corporations to invest and consumers to finance home purchases, why not put that rate where the Federal Reserve wants it rather than leave it to the whims of the market?

True Meaning

It was during the 2003 deflation scare (real or imagined by policy makers) that then-Fed Governor Ben Bernanke proposed buying bonds as a form of unconventional easing. (The Fed never implemented the idea.) Why wait for a crisis to put the plan in place?

The relevance of the funds rate, at which banks borrow from one another for last-minute funding needs or to satisfy their reserve requirements, has nothing to do with the volume of transactions at that rate. Its importance lies in what it says about the thrust of monetary policy or, to put it another way, about the impetus for the central bank to create money.

When the funds rate is significantly below the long-term rate, the Fed has to create excess money to keep it there. Otherwise, it would rise in response to the same forces -- supply and demand -- pushing up long rates.

Alternatively, when the short rate is above the long rate, the central bank has to withdraw liquidity from the banking system to keep the funds rate from following long rates down.

Party Line

The notion that the funds rate is inconsequential always gains popular appeal at a time when the Fed is embarked on a series of interest-rate changes, the results of which have yet to manifest themselves. The leading purveyors of that idea are the keepers of the flame.

Fed Chairman Bernanke pretty much summed up the official party line in a March 30, 2005, speech, when he was one of seven governors on the board. The Fed has ``no direct control over the key interest rates and asset prices that jointly determine the extent of financial stimulus,'' Bernanke said. Instead, policy makers are stuck setting ``an otherwise obscure short-term interest rate, the federal funds rate.''

If, as Bernanke said, ``Monetary policy is effective only to the extent that Federal Reserve actions can affect a wide range of interest rates and asset prices,'' why choose such a lowly instrument for the policy rate? Why not choose the rate that matters?

Challenging the Gospel

I can hear Bob chuckling and see him shaking his head. He said the short rate has a much closer relationship to future economic activity than the long rate. In a 1996 paper, he tested the two rates, which normally move together, and found that to be the case. Bob said the widely held view that long rates are inversely correlated with the economy and are the primary channel of influence ``has both conceptual and empirical problems.''

For all its rhetoric on the central role of long rates in the economy, the Fed does find a need to adjust the short rate, even when long rates are behaving propitiously. In the fall of 1998, for example, following Russia's default and the near collapse of hedge fund Long-Term Capital Management, the yield on the 10-year Treasury note plummeted almost 150 basis points in two months to 4.1 percent, a record low at the time.

Yet the Fed felt compelled to lower the funds rate three times by a total of 75 basis points. Why bother if the entire spectrum of market rates -- the ones that presumably matter -- had taken a dive?

Inside Joke

We've just about reached the point in the business cycle where analysts conclude that interest-rate increases aren't working. Until recently, it was those stubborn long-term rates that were blunting the impact of the 375-basis-point increase in the funds rate.

Whenever the first of those stories would appear in the press, Bob and I would get a good laugh. He was amazed that, as he put it, I would get two ``freebies,'' two chances to set the record straight, per cycle: one at the peak, and one at the trough.

He was right, just as he was about so many other things.

To contact the writer of this column: Caroline Baum in New York at cabaum@bloomberg.net.

Last Updated: April 6, 2006 00:07 EDT