When Federal Reserve Chairman Alan Greenspan and central bankers began raising interest rates last June, the decision to go ahead was a no-brainer. After all, at 1%, the federal funds rate was well below what economists call the equilibrium interest rate, which perfectly calibrates the economy, neither spurring inflation nor dampening growth. But after seven months of steadily raising rates, the Fed is finally being forced to confront the question of where that magical level lies.
The problem, as Greenspan told the Senate Banking Committee on Feb. 15, is that "we don't know what the actual rate is." Historically the inflation-adjusted fed funds rate has averaged about 2.5%, suggesting that's as good a starting point as any in trying to determine equilibrium. At the current 1.5% inflation rate, the neutral, or equilibrium, fed funds rate should come out at roughly 4%. But mindful of all the uncertainties in the economy, Fed officials currently reckon the zone of neutrality is anywhere from 3% to 5%.
That's a huge range, leaving Fed officials pondering how much more they need to raise rates. Six bumps since June have brought the funds rate up to 2.5%. No one at the Fed is suggesting that they should stop there. Still, two distinct camps inside the central bank seem to be emerging: those who believe short-term rates need to go significantly higher to remove excess liquidity from the economy, and those who fear the consequences of pushing rates much above the lower end of the range at 3%.
DRAGS ON GROWTH
The first -- the "we've only just begun" group -- consists mostly of regional Fed bank presidents. They argue that higher rates are needed to keep the U.S. economy on an even keel as strong productivity growth stokes demand for capital. And they fret that the Fed's easy monetary policy has led to speculative excesses in financial markets. The second group, the "we're almost done" camp -- mostly Fed board members in Washington -- is against pushing short-term rates up much more. They insist low rates are needed to help offset the drags on growth from high consumer debt and the big U.S. trade deficit. They see the current low yields in the bond market as a vindication of that view.
Where does Greenspan stand? He hasn't said, but the betting is that he will side with his fellow board members rather than with the more hawkish regional Fed presidents. Right now Greenspan seems to straddle both camps. In his Feb. 16 testimony to Congress, he said the Fed had raised rates "significantly" although they still remain "fairly low."
Both sides make compelling arguments. The hawkish group argues that strong productivity growth means the funds rate should climb to the top of the 3% to 5% neutral zone, above its long-term real average. Strong productivity growth, they say, should induce businesses to invest more. The rising demand for capital puts upward pressure on interest rates. If the Fed resists that and keeps rates down, it risks overheating the economy.
Indeed, there are signs that companies' animal spirits are stirring. Merger and acquisition activity has taken off. Business borrowing is picking up. What, then, do the inflation hawks at the Fed make of the low yields prevailing throughout the bond market, from Treasury and corporate securities to emerging-market debt and junk bonds? Perhaps, they say, it's a sign that monetary policy is still too easy. With short-term interest rates remaining low, investors have felt compelled to buy any asset where they think they can pick up some yield, be it junk bonds or emerging-market debt. What's more, some Fed officials fret, the central bank may have lulled investors into a false sense of security with its stated intention to keep hikes "measured." In a speech on Jan. 10, Atlanta Fed President Jack Guynn bemoaned the fact that some investors see that declaration as a stronger commitment than it actually is.
AWASH IN SAVINGS
Those at the fed who worry about going too far see things the opposite way. To them, the low bond yields worldwide mean that the Fed should be cautious about pushing short-term rates up too high. They contend that global bond markets indicate that the world is awash in savings. That's why most countries, with the exception of the U.S., are running current account surpluses. These nations, including Japan and Germany, lack adequate investment opportunities at home to put their money to work, leaving real yields low worldwide. Even with the big U.S. budget deficit, the inflation-adjusted yield on the Treasury's 10-year note is running at about 1.5%, well below its long-run average of closer to 3%.
There are more reasons for the Fed to be slow to push short-term rates too far above 3%, say policymakers. Fed Vice-Chair Roger W. Ferguson Jr. suggested in a speech late last year that the Washington's drive to slash the $412 billion budget deficit -- if it succeeds -- could check growth and thus inflation, an argument for relatively low interest rates. A move by debt-laden consumers to cut borrowing could have the same effect, although there's hardly a sign of that happening yet.
So far, the Fed has had an easy time raising interest rates. Inflation has stayed low, growth has been steady, and the financial markets have remained calm. But now its task is getting trickier -- and the debate inside the Fed over what comes next will only grow more pointed.
By Rich Miller in Washington