The Fed and You: Some Pointers

By talking market rates higher without actually tightening, the Fed can let the bond market do its job for it. Right? Nope.
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Guns and Roses (or Long Live Axl)

JACKSON HOLE, Wyo. -- And today we put forth a challenge.

Here's a sentiment your narrator comes across a lot lately; surely you've also heard it.

The Fed should not raise the federal funds rate, but it should announce a bias to tighten; jawboning rates higher will produce the desired economic-slowdown result. By talking market rates higher without actually tightening, the Fed can let the bond market do its job for it.

Sounds reasonable -- convincing, even -- does it not?

The chief economist at

Merrily Lynch

thinks so. So does The Best Fed Watcher Ever (the one who works for a Washington newspaper), so do the scores of analysts who write the scores of market research letters that pour in here every day, and so does some blonde guy named Erik who refuses to keep himself out of my televisions.

There's just one small problem.

This correspondent contends that there exists no hard evidence to support such a claim.

Thus the challenge:

Step into the ring with Axl and cite the periods in postwar U.S. economic history during which rising market rates produced material economic slowing in the absence of Fed action.

It did not happen, contrary to popular opinion, as recently as 1993. The bond yield settled at 5.78% on Oct. 15; it then rose nearly 60 basis points in less than three months to close the year at 6.35%. This had people unafraid; market participants found it comforting. Toward the end of 1993 spending for business equipment was accelerating at a 10.2% rate (compare to 8.6% now), spending for retail goods was accelerating at a 6.6% rate (compare to 8.5% now), and personal consumption was growing at a 5.2% rate (compare to 6.5% now), but not to worry: The increase in market rates would cool the economy and keep the Fed from coming in to tighten.

Uhh ... no. As one astute economist on television pointed out this morning, that's not how monetary policy works.

Rising market rates don't produce economic slowdowns. Rather, market rates rise ahead of the Fed action that produces economic slowdowns.

The 1993-1994-1995 period is a perfect example. Again, the bond yield rose to 6.35% from 5.78% over the final quarter of 1993; the yield on the two-year note rose to 4.25% from 3.81% over the same period. Economic growth accelerated to 3.5% in 1994 from 2.3% in 1993 (a result of the funds rate being kept at an ultralow 3% throughout 1993) but then decelerated sharply to 2.3% in 1995 (keep in mind that interest rates impact real economic activity with a lag that most put at between one year and 18 months).

Was it a rise in market rates that produced the slowdown? No. Rather, market rates rose ahead of Fed action to come (keep in mind that the short end of the yield curve represents the market's predicted time path of the policy

or fed funds rate and that the long end moves in response to changes in inflation expectations and-or the demand for credit). Indeed, on Feb. 4, 1994, the Fed embarked on a tightening cycle that would jack up the funds rate to 6% from 3% in just under a year.

And

that

is what produced the 1995 slowdown.

So one more time: Economies do not just up and brake all on their own, and a rise in market rates will not "do the work" for the Fed. Monetary policy is currently so accommodative that this economy is unlikely to slow materially even if bond yields hang at 5.9% for the remainder of the year. If the Fed wants the economy to slow appreciably, it's eventually going to have to come in and do something about it.

Again: The challenge is to cite the periods in postwar U.S. economic history during which rising market rates produced material economic slowing in the absence of Fed action, and your narrator will report back when one of the parties who keeps saying they exist rises to it.

Side Dish

Check out the

Jenny Jones

dig in the Commentary section of the

Journal

today. Then write

letters@thestreet.com and ask

Kansas

to pay that Nick guy whatever he wants to write things for us.