Commentary: The Bond Markets Need A Reality Checkby
Some people just won't be convinced. Annual inflation has been 3% or less for six years running. The Consumer Price Index is up barely 1.5% this year--and wholesale prices have actually been falling. But no sooner had the Federal Reserve decided on Aug. 19 to leave short-term interest rates alone than inflationphobes began muttering about a rate rise the next time the central bankers meet.
In truth, inflation-adjusted interest rates are stubbornly high, raising the cost of capital and deterring investment. With rates on one-year Treasuries hovering at 5.4%, short-term borrowers are paying a steep 4% inflation premium for their money--the highest in a decade. It is even worse for those seeking long-term money (chart). Says Brian Wesbury, chief economist of the Chicago investment firm Griffin, Kubik, Stephens & Thompson Inc.: "We are very close to price stability. But real rates are high and getting higher."
FALLING FORECAST. Looking down the road, economists surveyed by the Federal Reserve Bank of Philadelphia and the private Blue Chip Economic Indicators in Sedona, Ariz., expect annual inflation of 3% or lower for the next decade. The consensus inflation forecast has been falling for the past 17 years. Yet a 10-year Treasury bond is paying 6.21%, a stiff 3.2 percentage-point premium over long-run expectations and a nearly 5-point add-on compared with today's price level.
Rates remain high because investors haven't forgotten the brutal days of 1981, when long rates peaked at 15%, and 1982, when inflation topped 13%. Those memories still send Wall Street types into a cold sweat at any sign of wage or price rises. Says Smith Barney Inc. economist Mitchell J. Held: "It takes a long time to forget."
Held figures the average inflation premium for long-term government bonds has run about 2.84% since 1960. But since the inflation scare of the 1980s, real rates have fallen that low only twice--and each time just briefly. In July, even Fed Chairman Alan Greenspan conceded the point to a congressional committee. "There is still a significant inflation premium built into long-term interest rates," he said.
Bond yields are also being propped up by the stock market. Investors have little appetite for a 6.5% coupon on a long-term Treasury bond when an equity index fund offers triple the return, with little perceived risk. A 20% correction in stocks might change that psychology--and send bond yields plummeting. But that hasn't happened yet.
COSTLY CAPITAL. Demand for money also may be keeping yields high. Borrowers, awash in profits, are willing to pay top dollar for capital. And globalization has domestic and overseas borrowers competing for loans at relatively high rates. In France, the inflation premium for long-term bonds exceeds 4.5 percentage points, according to the Conference Board.
At least one perennial reason for high real rates in the U.S. seems to have faded. Public-sector borrowing, which peaked at $360 billion in 1991, fell to less than $100 billion last year. In 1997, it is likely to plunge even more as the federal budget nears balance, and state and local governments run growing surpluses.
REAL GAINS. But it will take more than a drop in government borrowing to push rates lower. For the market to forgo a big inflation cushion, investors must be convinced that recent productivity gains are real. While Fed Chairman Greenspan is intrigued by the theory that a new Information Age could create noninflationary employment growth, no one expects the Federal Reserve to base cuts in short-term rates on faith. And for now, growth is still too strong for the central bank to lower rates.
The fact is, as inflation slows, the Fed is squeezing the economy merely by holding short-term rates steady. And the time may be coming when investors themselves recognize that prices are stable and start accepting lower rates. At that point, the central bank may follow suit. For the time being, the financial markets may not be quite convinced that inflation will remain tame. But with stock market valuations at a historic high, and inflation at a 30-year low, the economic reality is going to become ever more persuasive. And that makes it a lot easier to believe that sometime soon interest rates are going to fall.