Sept. 21 (Bloomberg) -- It's no secret the Federal Reserve holds sway over the entire spectrum of short-term interest rates.

In fact, the front end of the yield curve responds less to the forces of supply and demand -- the short market is very ``thick'' -- than to expectations about the overnight federal funds rate.

How does the Fed do when it tries to broaden its sphere of influence to include long-term rates?

OK, it turns out. In a new paper entitled, ``Monetary Policy Alternatives at the Zero Bound: An Empirical Assessment,'' by Fed governor Ben Bernanke, Fed economist Vincent Reinhart and Brian Sack of Macroeconomic Advisers in St. Louis, the authors conclude the central bank can shape expectations about future interest rates, and hence affect current rates, thereby providing added stimulus to the economy.

On one level, the observation is a statement of the obvious. If the central bank promised to hold the overnight funds rate at 1 percent for five years and the bank was credible, the yield curve would be flat out to five years.

On another level, unconventional policy options were a real possibility last year when the Fed was confronted with short-term rates near zero and low and falling inflation. Those options included quantitative easing (buying more government securities); buying long-term bonds outright to lower their yields; and using communication policy to alter interest-rate expectations, and hence current rates.

Guidance Counselor

Under those circumstances, ``the central bank may be able to impart additional stimulus to the economy by persuading the public that the policy rate will remain low for a longer period than was previously expected,'' Bernanke, Reinhart and Sack said in their paper.

Such a commitment, ``if credible and not previously expected, should lower long-term rates, support other asset prices, and boost aggregate demand,'' they said.

Traditionally, the long end of the yield curve dances to its own drummer. Because a bond investor may hold his security for a long time, he has to be compensated for any erosion in the dollar's purchasing power. For that reason, bond yields consist of a real rate of interest (the real cost of borrowing) and inflation expectations.

To the extent that the long rate is the sum of the current and future expected short-term rates, a road map from the Fed can influence long rates.

Land Mines

A road map can be redrawn quickly, however, when the economic news changes. Which is exactly what happened last year, and why cartography should not be part of the Fed's job description. The Fed can't guarantee a future policy course when the course is dependent on future data.

Contrary to the Fed's glowing self-assessment of its communication policy, bond traders and investors don't remember last spring as the Fed's finest hour.

The mention of an ``unwelcome substantial fall in inflation'' in the statement following the May 6, 2003, meeting plus intimations elsewhere of possible purchases of long-term bonds sparked a huge rally in the Treasury market. The yield on the 10-year Treasury note tumbled 80 basis points to a record low of 3.07 percent in six weeks as traders sought to front-run what they thought would be the presence of a price-insensitive buyer in the market.

Volatility

Fed Chairman Alan Greenspan poured fuel on the fire in early June, when he said policy makers needed a wider ``firebreak'' to guard against deflation and ``insurance against economic weakness.''

Apparently 25 basis points -- and none of the bond purchases hinted at earlier -- were all the firebreak/insurance the Fed thought necessary at the June 25, 2003, meeting.

Ten-year Treasury yields soared 150 basis points in the next eight weeks, the biggest increase in such a short period of time since 1987, according to Jim Bianco, president of Bianco Research in Chicago.

Any benefit from the decline in yields, short-lived as it was, was canceled out by the extreme volatility.

In fact, the communication was such a disaster the Fed formed a working group to study its communication policy. Policy successes don't generally breed committees.

What's the Point?

There's no question the Fed, which is meeting today, can influence long-term rates by what it says and does. Run inflationary policy, and you can be pretty sure bond yields will rise. State your intention to maintain high real short-term rates in the face of a recession, and bond yields are going to tumble.

The real question isn't what the Fed can do; it's why can't the market, given appropriate information about the central bank's policy objectives, figure things out for itself?

``Is there some dysfunction in the market that the Fed is looking to address?'' said Jim Glassman, senior U.S. economist at JPMorgan Chase & Co. ``Why wouldn't bond investors drive long- term rates down in the face of a deflation threat? It implies the Fed has superior knowledge'' -- something the Fed itself dismisses -- ``and an inability of the market mechanism to adjust to a deflation threat.''

Bernanke et al acknowledge as much in their paper.

``Changes in the perceived risk of deflation would affect long-term yields independent of supply-side effects,'' the economists said in reference to the decline in long-term yields on expectations of outright bond purchases last year.

Not Unanimous Consent

Not all Fed officials are on board with the policy of hands- on guidance. St. Louis Fed President Bill Poole, an advocate of increased transparency through a clearly stated objective (preferably an inflation target), is one of a handful of Fed bank presidents who would prefer to keep the future conditional out of Fed statements.

``Explaining a policy action... is worthwhile,'' Poole said in an Aug. 21, 2003, speech at the Federal Reserve Bank of Philadelphia. Discussing future policy actions, which ``are almost entirely contingent on the arrival of new information,'' is ``probably counterproductive'' and ``more likely to be misleading to the market than helpful,'' he said.

With inflation in the industrialized world trending lower over the past two decades, it's nice to know empirically that unconventional policies work, that what the Fed says matters.

If Fed policy makers can shape expectations with 150 tortured words sandwiched into a five-paragraph statement every six weeks, just imagine what information they could impart at a monthly press conference.

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

Last Updated: September 21, 2004 00:04 EDT