It would be easy to think of Tuesday's Federal Reserve Board meeting as a non-event. After all, the U.S. economy seems to be picking up a bit of steam, and most economists expect the central bank to hold its benchmark lending rate steady (in fact, the Fed did just that, saying spending is firming up but deflation remains a concern). Beneath the surface, however, there is an awful lot going on — and most of it has to do with whether the bond market has lost its faith in Fed chairman Alan Greenspan. If it has, the economic consequences could be fairly serious.
As most people know, the U.S. central bank tries to promote economic growth by keeping interest rates low, something it achieves by raising or lowering its overnight lending rate (the rate that banks charge other banks). In theory, this in turn affects interest rates throughout the financial system, which helps to stimulate or retard the advance of the U.S. economy, depending on what the Fed has in mind.
Stories about Mr. Greenspan often make him sound like an almost omniscient being, a master engineer who pulls this or that lever and tinkers with the settings on the central bank engine until the U.S. economy is humming along at just the right speed. The reality, however, is that the financial markets are an unruly beast, driven by a range of short- and long-term factors — both real and perceived.
That's why the Fed spends a lot of time trying to communicate its intentions to the market — through the statement released with each Fed meeting, as well as the central bank's "Beige Book" and Mr. Greenspan's appearances before the U.S. Congress. In economic terms, this is known as using "moral suasion," but many traders call it "jawboning the market." Mr. Greenspan is often seen as a master of this particular art, but even The Maestro makes mistakes sometimes.
One of the biggest burrs under the Fed's saddle during the economic downturn has been the way longer-term interest rates stayed relatively high, even as short-term rates fell to 40-year lows. While homeowners were happy to ramp up their mortgage refinancing activity thanks to low short-term rates, high longer-term rates kept business spending muted. The problem was how to bring long rates down.
Earlier this year, the Fed started talking openly — for the first time — about the risk of deflation, and the various ways the central bank could offset that risk. Some Federal Reserve officials even mused about going outside the Fed's normal practice and buying long bonds directly, in order to drive longer-term interest rates down (rates move in tandem with bond yields, which fall when bond prices rise).
These musings did the trick. Long-bond yields went into free fall, dropping by the largest amount since recession fears laid waste to bond yields in 1980. Traders bought in for a variety of reasons: some thought that the Fed might actually make good on its bond-buying speculation if further rate cuts weren't enough to budge the economy, while others saw even the discussion of such a move as a sign that the economy was still weak, making bonds still look attractive.
Unfortunately for the bond bulls, however, Mr. Greenspan and his gang didn't follow through on any of those expectations at the Fed's June meeting. In fact, they only cut rates by a quarter of a percentage point rather than the half-point cut many traders were expecting, and then in July the central bank said measures such as bond purchases were unlikely. Where did bond prices go? Into the tank, sending yields higher and undoing the work of the previous few months.
In fact, 30-year mortgage rates have climbed to the point where some economists are concerned that the mortgage-refinancing boom could be choked off, removing what has been one of the pillars of the U.S. recovery over the past three years. Mortgage refinancing rates have dropped by about 60 per cent. High long-term rates could also imperil a broad recovery in business spending and industrial activity, something many economists have been waiting for since 2000.
In other words, the dramatic yo-yo effect the Fed's comments produced in the bond market has had a very real impact on the economy, an impact that is the exact opposite of the one the central bank was hoping for (although the bond selloff may have been accelerated by other factors as well). That means Mr. Greenspan will be choosing his words with even more care than he usually does, for fear of exacerbating the problem. It's not so much about cuts right now — it's about perception.
If the Fed seems to be too positive about the strength of the economy, for example, bond prices will likely suffer — since this would suggest no more rate cuts, and possibly even rate hikes. As a result, yields will rise, pushing long-term rates higher. But if the Fed comes out with a pessimistic report about the economy, the bond market may not believe it, given what some traders see as the central bank's about-face in June. They may even do the opposite of what's expected.
In the end, the Fed's job depends as much on expectations and trust as it does on the actual mechanics of setting the central bank rate. Tuesday's meeting — and the fallout from it — will put those factors to the test, regardless of whether there is a rate cut or not.
E-mail Mathew Ingram at mingram@globeandmail.ca
Look for exclusive Mathew Ingram commentary at GlobeInvestorGold
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