Questions, and an Answer, for Ben Bernanke

The obsessive focus on long-term interest rates is misplaced, when the yield curve -- encompassing long- and short-term rates, is the key to understanding the economy's direction.

Federal Reserve Chairman Ben Bernanke was asked at two appearances before congressional committees this week about rising long-term interest rates. Treasury note and bond yields have soared as much as 130 basis points since early May, when the chairman broached the subject of tapering the Fed's monthly asset purchases. Since then, in spite of his repeated efforts to soothe the bond market, long-term Treasuries have recouped only a small portion of their losses.

Yesterday, Bernanke told the Senate Banking committee that some of the increase in rates reflected improved economic conditions (interest rates move pro-cyclically). Another part of it was the result of an unwinding of leveraged positions, which he said was good, but "the tightening that's associated with it is unwelcome."

Since no one asked, I have a couple questions for the Fed chief. First, if long-term rates are what drive the economy, why does every central bank on the planet choose to target a short-term rate? During and after World War II -- until the Fed-Treasury Accord of 1951 -- the Fed kept all interest rates within prescribed ranges amid huge swings in inflation. So it can be done.

Second, why is the slope of the yield curve, or the gap between a Fed-influenced short-term rate and a market-determined long-term rate (at least under normal circumstances), one of the best predictors of the business cycle? The yield curve is the leading-est of the leading indicators. It inverted in mid-2006, giving an early warning of recession. Policy makers ignored the signal, as they usually do, offering a reason -- the "savings glut" -- why this time was different.

The focus on long-term rates is misplaced. The overnight rate reflects the supply of credit. It's the price at which the central bank is willing to supply unlimited credit to the banking system. The long rate reflects the demand for credit, as well as inflation expectations. It's the interaction of the two rates that encapsulates the stance of monetary policy. Looking at the long rate in isolation tells you nothing.

For those who think long rates hold the key to the economy, here's a guaranteed way to bring them down. Raise the overnight rate by a couple of hundred basis points. Long rates will tumble. Of course, the yield curve will invert and kill the economy in the process. The Fed can accomplish this without clear communication, or any communication whatsoever.

Hopefully this will help you put the long-rate folderol in perspective.

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    Caroline Baum

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