Are Interest Rates On The Rise?

With inflation tame and credit demand low, a boost isn't imminent. Still, Greenspan wants to leave himself a little leeway

It certainly was a shocker. The Federal Reserve caught nearly everyone on Wall Street by surprise on Jan. 28 when it backed away from its promise to keep interest rates low "for a considerable period." Financial markets immediately took fright. Bond prices tanked, pushing the yield on the key 10-year Treasury note up to 4.19%, from 4.06%, just before the Fed's announcement. And stock prices nosedived, with the Dow Jones industrial average posting triple-digit losses. To many, the Fed's message was clear: A rate hike is in the offing. The days of easy money are over.

Well, not exactly. Yes, Fed Chairman Alan Greenspan and his colleagues inched closer to an eventual tightening of credit by altering the language in the statement they issued after their two-day meeting. No longer are they talking about keeping monetary policy easy for some time. Instead, they're saying they can afford to be patient when it comes to raising short-term interest rates. "They're removing the 90-day money-back guarantee that rates would stay unchanged," says Louis Crandall, chief economist at consultants Wrightson ICAP LLC.

STAYING PUT. But that doesn't mean interest rates need to rise right away. Nor does it mean they will have to rise quickly once the Fed decides to move. What will ultimately determine their direction is the outlook for the economy and inflation, and the demand for credit. On that basis, there are reasons to believe both short- and long-term interest rates, on everything from Treasury securities to home mortgages, can stay low for some time.

The economy is surely gathering steam. But so far the faster growth hasn't led to a pickup in inflation that would prompt the Fed to hike rates. Nor has corporate credit demand taken off, since surging profits have allowed companies to finance investments without having to turn to the banks or the bond market for money. And while government borrowing has exploded -- courtesy of the bulging budget deficits -- so far it has been more than offset by stepped-up buying of Treasuries by central banks in Japan, China, and other Asian countries.

Then why did the Fed decide to roil financial markets by altering the language in its statement? For one thing, many at the Fed have been uneasy with the central bank's implicit promise to keep money policy easy ever since it first made it back in September. They felt it boxed them in. And they wanted the leeway to raise rates when necessary without having to worry about breaking a promise to the markets.

To be sure, Fed officials were aware financial markets would tumble on the rewording. Yet they may not be all that unhappy. Some officials felt the pledge of easy money had become an unhealthy preoccupation of the markets; they would prefer the markets focus on economic fundamentals than endlessly parsing the Fed's use of the word "considerable." If investors then push up long-term rates in response to the changing conditions in the economy, it will also make it easier for the Fed to follow suit with a rate hike of its own, especially in the heat of a Presidential campaign.

That's of little immediate comfort to the markets, though. Bond pros complained that the Fed once again had misled them about monetary policy, just as it did last year with its statements about the dangers of deflation. Indeed, the markets had been primed in December for a shift in the statement's wording. But none came.

Instead, the Fed moved now, when no one expected it. Fed officials say the shift in wording came after a larger discussion about how the central bank communicates with the markets. The upshot of that discussion: a determination by the Fed to move away from the straitjacket of set statements so that it can more easily reflect changes in the economy when communicating with the markets.

The Fed's message on Jan. 28 was nuanced. It signaled that it was a step closer to tightening credit. But it also made clear that it was in no big hurry to raise rates and did not see the need to boost them quickly once credit tightening has begun.

What's most important, from the Fed's point of view, is the outlook for inflation. And if anything, the recent signs have been that it's ebbing. Core inflation -- as measured by the personal consumption price index, excluding food and energy -- was a mere 0.8% in December. While some Fed officials suspect the index may be overstating how far inflation has fallen, there's no doubt it's still very low, says economist Bruce Kasman of J.P. Morgan. And inflation expectations, as measured by the Treasury's 10-year, inflation-protected securities, show signs of stabilizing after rising last year.

Faster economic growth may not be generating much in the way of inflation, but it's sharply boosting corporate profits. That should help ease some of the upward pressure on interest rates by holding down demand for bank loans, which usually materializes in a recovery. Companies that want to step up capital investment have the cash to do so without borrowing from banks or the bond market. According to the Fed, nonfinancial corporations generated nearly $80 billion more internally than they spent on investment in the third quarter, on an annualized basis. Given strong fourth-quarter profits, internal cash flow should rise further.

What's more, many corporations locked in low-cost financing by selling bonds in 2003, when issuance ballooned by more than 20%. "Companies opportunistically 'prefunded' themselves," says Diane Vazza, head of Standard & Poor's global fixed-income research group. As a result, there's a chance that corporations might issue fewer bonds this year than last.

Of course, Uncle Sam's borrowing binge could put upward pressure on interest rates. The Congressional Budget Office said on Jan. 26 that the deficit will rise to a record $477 billion in the fiscal year ending Sept. 30, from $374 billion the previous year. And there's more red ink to come, with the CBO projecting total deficits of $1.9 trillion in the next 10 years. But so far at least, those extra Treasuries are being absorbed by Asian buyers. Fed data suggest that foreign central banks bought a staggering $33 billion worth of Treasuries in the last month alone. What the Asian banks are doing is recycling the dollars they buy in the currency market back into Treasury securities to try to keep the greenback from falling too far. And while the Fed's word-tweaking did spark a dollar rise on Jan. 28, most experts think the long-run trend in the buck is still downward because of the twin U.S. deficits of trade and the budget.

The Fed caught the markets short with the unexpected abandonment of its easy-money pledge, and long-term interest rates jumped in response. But with inflation low, productivity strong, and profits booming, there's little reason to fear that a damaging surge in rates is on the horizon.

By Rich Miller in Washington

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