Interest Rates: Why The Vaccine Isn't Taking

Before the Federal Reserve Board raised short-term interest rates on Feb. 4, some economists and market watchers had hoped that such a move would paradoxically bring down long-term rates. Long rates, they reasoned, are heavily influenced by investors' expectations of future inflation. So a display of muscle-flexing by the Fed now would convince the financial markets that low inflation was here to stay. That would give the U.S. the best of both worlds--low inflation and low long-term interest rates to boost investment.

So far, though, the optimists have been disappointed. Since the Fed raised short rates, interest rates on the 30-year bond have risen from 6.31% to 6.60% on Feb. 22. This is in spite of a report that consumer prices in January were unchanged, indicating that inflation is still dormant.

Why did long interest rates rise? In part, it's because of a perception that the economy has finally managed to achieve a sustained recovery. As business improves, demand for loans will rise, pushing up long interest rates.

More important, history shows that the market mavens were wrong to start with. Long rates almost always rise when the Fed boosts short rates. Since 1971, there have been only two years when a higher short rate was accompanied by a lower or constant long rate. The most recent was 1989, when the Fed, led by Chairman Alan Greenspan, pushed up short rates by almost two percentage points compared with 1988. Over the same time, the average interest rate on 10-year bonds dropped by about half a percentage point.

But such experiences are the exception, not the rule. That's true for other economies as well. Since 1971, Japan has had only two years when short rates rose and long rates fell, and Britain has had only one.

The one country where the central bank has succeeded in bringing down long interest rates by raising short rates is Germany, which has pulled off that trick four times in the past two decades. To do this, "you need an institution that has as much credibility as the Bundesbank," says Elliott Platt, who is director of economic research at Donaldson, Lufkin & Jenrette Securities Corp. And so far, that's a level of credibility that Greenspan's Fed has been unable to establish.

    Before it's here, it's on the Bloomberg Terminal.