THE BOND MARKET IS SPOOKED SILLY--TOO SILLY
There's no pleasing this bond market. It's got inflation on the brain. Not even the best monthly showing in the consumer price index in 4 1/2 years made any difference. Tough talk from Federal Reserve Board Chairman Alan Greenspan helped a little, but not for long.
Bond prices have been in a dizzying decline since the Fed's quarter-point hike in interest rates on Feb. 4. The yield on 30-year Treasuries jumped from 6.31% to 6.64% on Feb. 22, minutes before Greenspan's semiannual Congressional testimony on monetary policy and the economy. Somewhat perversely, that rise is even greater than the Fed's nudge to short-term rates. Long rates are now sharply higher than their October, 1993, low of 5.78%.
The bond market has a worry list a mile long. To begin with, it fears that the economy is in a boom and that the Fed is already behind the game in its inflation-control efforts. So, it believes the Fed has begun a series of rate hikes that will take short-term rates some one-to-two points higher in the coming year in an effort to thwart inflationary pressure.
Moreover, bond players see inflationary potential in a weaker U.S. dollar vs. the Japanese yen. Throw in an uptick in commodity prices amid rising capacity utilization rates, and you've got one scared bond market. The problem is, there's not enough substance behind any of these concerns to justify the recent sell-off in bonds.
Against this backdrop, the Fed chief trekked up to Capitol Hill to lay out the central bank's strategy, including the Fed's latest economic projections (table). But even though he was talking to Congress, his message was clearly aimed at the bond market.
Greenspan repeated a lot of old themes, including the need to raise real short-term interest rates and the battle to contain inflation expectations, a component of long rates. His hawkish words on inflation eased the bond market's tensions, as 30-year Treasuries closed at 6.60%. But the next day, the yield jumped back up to 6.65%.
The Fed chief did, however, outline some key indicators of inflation expectations. They include the yield curve, exchange rates, and even gold prices (page 44). Greenspan also suggested that price-indexed bonds--currently issued in Britain, for example, but not in the U.S.--could contain information on expectations.
On balance, the tone of the chairman's remarks suggested that the next tightening of policy would be sooner rather than later. The Fed's next policy committee meeting on Mar. 22 could provide the setting.
Greenspan also tried to allay the bond market's main concern right now: the strength of the economy. Yet another December indicator, the trade deficit, came in far better than expected. Now, a few economists look for the 5.9% surge in real gross domestic product last quarter to be revised higher still, to around 7%.
However, the economy seems likely to slow to about half that pace in the current quarter, and the drags from fiscal restraint in the U.S. and recessions in Europe and Japan will weigh on growth for the rest of the year. Once the economy shows signs of more moderate growth, long-term rates should start to head back down.
Consumers will be hard-pressed to maintain last year's heady pace of spending, although buying should continue to rise. Consumer confidence slipped a bit in February. The Conference Board's index fell to 80.8, from 82.6 in January, but the Board suggested that the nation's dreary weather may have dampened consumers' spirits. Households still see their present economic situations on an improving trend (chart).
In addition to slower growth, more evidence of tame inflation will take some air out of long rates. Unlike past expansions, excellent productivity gains are holding down unit labor costs, and the global slowdown is taking pressure off of U.S. production capacity.
Indeed, the consumer price index did not rise at all in January, and the core index--excluding energy and food--edged up only 0.1%. Despite the bond market's worries, inflation continues to trend downward. Inflation over the year stands at 2.5%, and core inflation fell to 2.9%--the lowest in three decades (chart, page 40).
Still, that may not be good enough for Greenspan & Co. While the chairman admitted that the CPI overstates inflation by 0.5 to 1.5 percentage points, he also warned that 3% inflation is not price stability. The message: The Fed will do what's necessary to drive inflation even lower.
Part of January's stellar performance stems from the Labor Dept.'s overhaul of the CPI's seasonal factors. The government is now seasonally adjusting 50 of the 60 price categories in the monthly report, instead of just 33. That enhancement reduces the tendency of the index to overstate inflation in the early months of the year. Under the old procedure, the CPI would have risen 0.3%.
Greenspan's testimony also had a global slant. The Fed chief noted that low inflation will enhance the competitiveness of U.S. goods in world markets. He also listed the foreign-exchange value of the dollar as a clue to inflation expectations.
But if that's the case, the central bank cannot be too happy with the dollar's recent slide against other major currencies. The Fed may be worried that a sustained weakness in the dollar could be inflationary because of rising import prices. And that would give U.S. producers the opportunity to lift their prices.
Foreign trade was a big disappointment in 1993, but it did end the year on a strong note. A surprising 4.9% rise in exports, combined with a 0.6% slip in imports, narrowed the merchandise trade deficit to $7.4 billion in December, from $9.7 billion in November. That means that the Commerce Dept.'s revisions to last quarter's gross domestic product, due out on Mar. 1, will show an improved trade deficit.
Still, shifts in both imports and exports have damaged the U.S. trade position (chart). Imports soared by 9.3% last year, while exports managed just a 3.8% gain. As a result, our trade deficit for 1993 widened to $115.8 billion--the biggest gap in five years. The U.S. trade deficit with Japan alone hit a record $59.3 billion. The resulting trade tensions between Washington and Tokyo have only increased the bond market's jitters--making the Fed's job all the more difficult.
However, any concerns about the dollar should ease. That's because tighter U.S. policy comes as our major trading partners are trying to revive their economies. While the Fed is raising interest rates, the German Bundesbank is leading the rate cuts across Europe. And the fiscal restraint in U.S. federal spending contrasts with the looser purse strings in the Japanese budget.
Greater accommodation abroad is clearly necessary to foster solid recoveries overseas. Right now, the best hope is that Germany and Japan will turn around by the end of this year. Those recoveries should help to lift U.S. export growth in the second half. Imports, though, will continue to grow in line with U.S. domestic demand, suggesting that the merchandise trade deficit will remain a nagging problem this year.
The U.S. won't look so bad in global commerce when the next trade report comes out on Mar. 22. That's because Commerce will introduce monthly data on services. The U.S. holds a big surplus in services because our exports of intangibles like communications and financial information overwhelm our imports of services.
A wider trade deficit will act as a brake on economic growth in 1994, a crucial part of the Fed's forecast. The Fed's real concern, though, is not 1994. "We are focusing on 1995 and beyond," Greenspan told Congress. The goal: long-term interest rates lower in 1995 than they would otherwise be. And that would be good news for the economy as well as the bond market.JAMES C. COOPER AND KATHLEEN MADIGAN