Many folks in the bond market complain that the Federal Reserve has lost credibility because of the confusing way it communicates its policy. However, judging by the whipsaw pattern of long-term interest rates, that's like the pot calling the kettle black. In only three months, bond market players have swung 180 degrees, from worrying about deflation to fears of inflation. Talk about confused.
Given that inflation expectations are such an integral component of bond yields -- since a rise in inflation can erode future returns -- the bond market appears to be in a fog right now over the inflation outlook and what that means for Fed policy. Since mid-April, the yield on 10-year Treasuries has plunged from 4% to a 45-year low of 3.1% in mid-June, only to surge to 4.5% in mid-August, the biggest 11-week jump in 16 years.
Why the yo-yo move? In May and early June, bond folk believed deflation was such an imminent threat that the Fed -- which was running out of short-term rate ammunition -- would have to take the unusual step of purchasing long-term Treasury securities in an effort to combat it. Bond prices skyrocketed, and yields sank. Now, with the economy showing every sign of a significant acceleration in growth, the bond market fears rapid growth will fuel inflation and cause the Fed to tighten policy. The sell-off has sent yields sharply higher.
What the bond market is missing is that its worries about inflation are just as unfounded as its earlier concerns about deflation. With so much unused capacity around the world, particularly in the U.S. labor markets, with the dollar's decline now reversed, and with cheap imports still pouring in, especially from China, the chances of inflation picking up to any significant degree in the coming year are very small.
THE LATEST JUMP in bond yields is especially odd, given that the Fed's official statement after its Aug. 12 policy meeting said, "the Committee believes that policy accommodation can be maintained for a considerable period." That's about as plain as the Fed can be in saying that it has no intentions of raising rates anytime soon. Indeed, a statement like that, taken in the context of the Fed's own forecast of 3.75% to 4.75% economic growth in 2004, implies that the Fed does not believe that inflation is now, or will be, a threat.
The bond market isn't buying that notion. In fact, in the face of relentlessly good news on the economy, bond investors are now demanding increased protection against inflation. The spread between the yield on 10-year Treasuries and that for Treasury inflation-protected securities, called TIPS, has widened substantially in recent weeks, indicating rising inflation expectations. By Aug. 26, the spread had increased sharply, to 224 basis points.
Signs of a stronger economy continued in the latest week, as August consumer confidence rose, and July durable goods orders picked up, including another gain in capital goods. And housing held its ground in July, with sales of existing homes rising to a record, and demand for new homes slipping only a bit from June's record high. The July and August data suggest that 5% economic growth this quarter is not out of the question.
BUT EVEN IF THE ECONOMY picks up steam, inflation is not a worry because of the huge amount of slack created by the recession and the long period of subpar growth since the downturn ended in late 2001. Bear in mind that inflation pressures start to build only when overall demand starts to bump up against the capability of the economy's labor and machines to satisfy it.
But that point is a long way off. The ability of the economy to meet demand has risen. That much is clear from the ongoing trend in productivity growth, which along with additions to the labor force determines just how fast the economy can grow without generating higher inflation. Revised data suggest productivity last quarter grew in the range of 6%, at an annual rate.
More important, the 10-year growth rate of productivity has accelerated to 2.4%, about a percentage point faster than in the mid-1990s. Adding in the 1% growth rate of the labor force, this upshift means the economy is now capable of sustaining growth in the area of 3.5% over the long haul without lifting inflation.
But over the past three years, the economy has grown at an annual rate of only 1.4%, opening up a sizable gap between the amount of goods and services the economy is actually producing and the amount it is capable of producing. As a result, the economy could grow well above the 3.5% trend for perhaps a year or more without overextending its resources and creating inflation pressures.
NOWHERE IS THIS POINT clearer than in the labor markets, where businesses are relying on productivity to boost output instead of adding more workers. Since the recovery began in the fourth quarter of 2001, the economy has grown at an annual rate of 2.6%, but productivity has shot up 4.3%. That's why payrolls have continued to fall, lifting the unemployment rate to a nine-year high of greater than 6%. Even at 5% economic growth, it will take a long time to reach full employment. Don't forget that the jobless rate had fallen to 3.9% just before the recession began, with nary a sign that inflation was becoming a problem.
Households seem increasingly confident that the economy is improving, but they remain worried about jobs. The consumer confidence index, published by the Conference Board, rose to 81.3 in August, from 77 in July, but an increasing percentage of households said that jobs were still hard to get.
Consumers' assessments of present conditions remained dismal, but their view of the future brightened, as more households expect better business conditions and more jobs within the next six months. Nevertheless, it will take substantial growth in payrolls, of at least 150,000 slots per month, before the unemployment rate can begin a lasting decline, and those kinds of gains aren't in the cards anytime soon.
The final reason not to expect a surge in inflation is weak global conditions. Europe and Japan are each dealing with slack in their production capacity. Plus, the dollar is rising again, especially vs. the euro, as the U.S. outlook improves. The trade-weighted dollar, while down from its early-2000 high, is only back to where it was in the late 1990s, which was some 15% higher than it was in the mid-1990s. Because so many countries peg their currency to the dollar, including China, the greenback's power to buy imports is still relatively strong.
Without a doubt, the economy's acceleration makes the probability of inflation in the next year or so greater than the probability of deflation. But both still command very low odds. When the bond market finally begins to understand that, its herky-jerky behavior of the past few months will begin to even out.
By James C. Cooper & Kathleen Madigan