Fed is puzzled by little effect of rate rises on economy

On eve of ninth increase, mortgages are still low

June 29, 2005|By COX NEWS SERVICE

WASHINGTON - When the Federal Reserve Board's policy-makers meet today and tomorrow, they likely will raise short-term interest rates for the ninth time since last June.

Economic theory would tell you this should be rippling out through the economy by now, sending up long-term interest rates, including those on home mortgages.

But over the past year, long-term interest rates have fallen. The 10-year Treasury rate is down to 3.9 percent, compared with 5.33 percent a year ago. The average fixed-rate 30-year home mortgage has slipped to 5.57 percent, down from 6.25 percent a year ago.

This disconnect between short- and long-term rates, which Federal Reserve Chairman Alan Greenspan has called a "conundrum," has left even the best economists chewing their pencils.

"It's clearly without recent precedent," Greenspan told Congress this month, while assuring lawmakers that Fed economists "are spending a very considerable amount of time" trying to understand it "as best we can."

Here's how interest rate increases are supposed to work:

The Federal Reserve, the nation's central bank, establishes the direction of short-term rates by setting a target for the federal funds rate - the rate charged on overnight loans between banks. That target rate determines what banks will charge consumers for car and home-equity loans as well as credit-card debt.

The Fed's goal is to keep the U.S. economy on a steady growth path. So in 2001, when the economy fell into recession and terrorists attacked, the Fed started cutting rates to stimulate the economy, particularly consumer spending. In all, the Fed cut rates 13 times, sending rates to 46-year lows.

Inflation fears

In the past year, the Fed has concluded that the economy no longer needs such help. In fact, policy-makers are worried the economy could grow fast enough to send wages and prices into an upward spiral. They decided last June to start raising short-term rates to cool growth.

They are widely expected this week to raise the federal funds rate again by a quarter-point to 3.25 percent.

Many economists believe this measured effort has put the economy in a sweet spot, with growth running at about 3.5 percent, a healthy pace.

But some fear the housing market may be overheating, especially in key markets along the coasts. They'd like to see mortgage rates rise enough to discourage speculators from buying and "flipping" houses for quick profits.

It's not easy, however, to tap the brakes on mortgages because the Fed does not set those rates.

Market forces determine rates on the 10-year Treasury bonds that serve as a benchmark for mortgages.

Typically, investors insist that long-term rates be considerably higher than short-term rates because they want a premium for holding an investment over a longer time.

`Inverted yield curve'

But on rare occasions, long-term rates do get lower than short-term rates. Economists call that an "inverted yield curve."

Usually, an inversion signals a recession; investors think prices and interest rates will be slumping along with the economy. That's what happened in 2000 when the phenomenon was last seen.

But this time, the phenomenon seems not just rare, but abnormal. "It's the fastest decline that we have seen ... in many decades," Greenspan said. "Something unusual is clearly at play here."

Possible explanations

Economists are tossing out explanations that go beyond the usual recession scenario. Leading theories include:

Cheap labor is killing inflation. With vast numbers of low-wage workers in Asia, India and eastern Europe pouring into the global economy, wages will be falling for years. Investors don't need a big premium for long-term bonds because they don't see inflation coming.

Foreigners are saving too much. While Americans like to spend money, thrifty foreigners are creating a "savings glut." Germans, Asians and others are funneling their savings into U.S. Treasury securities, making rate increases unnecessary.

China's growth will be slowing. If China's economy were to tumble, demand for commodities would plunge and snuff out inflation.

Europe and Japan aren't growing. Because capital markets are globalized, weakness in Europe and Japan is driving down bond yields everywhere. A U.S. Treasury bond at 3.9 percent is attractive compared with a Japanese bond at 1 percent.

Wealthy countries are aging. As people get older, they tend to switch savings away from risky stocks and into safer government securities, driving down rates.

Greenspan told Congress all of the theories are "credible to one degree or extent."

Whatever the cause of the long-term rate drop, the impact has been good for the U.S. economy, at least for now. Cheap mortgages have pushed up home ownership rates to record levels.

Millions are richer

The robust housing market has made millions of Americans richer. The Fed reported that in the first quarter of this year, the value of all U.S. housing rose 15 percent from the same period a year ago.

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