Why We Were So Wrong About 2005

Of course, a strong dollar, which hurts U.S. exports, and higher interest rates at home, which dampen domestic spending, do add up to lower economic growth in the U.S. Not all at once. And not by a huge amount. But the drop from 4% growth in the third quarter of 2004 to 3.8% in the fourth quarter to 3.5% in the first quarter of 2005 does put the economy on a path that leads to growth nearer 3% by 2006.

The Role of Globalization

The big wild card in predicting anything about the economy these days is long-term interest rates. When the Federal Reserve raises short-term interest rates, long-term bond rates are supposed to climb. Historically, a 2-percentage-point climb in short rates, for example, has led to a 1-percentage-point climb in long-term rates. This time around, however, the Federal Reserve has raised its target for short-term rates by 2 percentage points -- to 3% from 1% -- in the last year, but yields on the 10-year Treasury note have tumbled to 3.9% from 4.7% in June 2004.

If you go back to the predictions made at the beginning of 2005, the consensus was that short-term interest would hit 3.5% or so by the end of the year. That looks about right, with Alan Greenspan signaling last week that the Federal Reserve will raise rates at the end of June and in early August.

But predictions that long-term rates would hit 5.5% or even 6% by the end of 2005 stand to be dead wrong.

The globalization of the financial markets has changed the way U.S. interest rates respond to rate moves by the Federal Reserve. Look at one popular trade now: borrowing in Asia, where interest rates are even lower than they are in the U.S., and then investing the proceeds in the U.S. bond market. It's pretty profitable when the overnight U.S. dollar LIBOR rate is at 3.03% and the Japanese LIBOR stands at 0.03%, as it did on June 9. (LIBOR, the London interbank offered rate, is available only to the most creditworthy of international banks. But it's often the base rate used in calculating the yield on other loans, so it gives a good idea of the spread.)