Letters. We Get Letters.

JACKSON HOLE, Wyo. -- A peek into the mailbag is in order.

88 Lines About 44 Women

Has the yield curve flattened?

Yes.

The 10-3 spread -- the difference between the yield on the 10-year Treasury note and the yield on the three-month Treasury bill -- averaged 116 basis points (or 1.16%) in January.

It stands at about 34 basis points (or bp) now.

Does this flattening necessarily ensure slower growth ahead?

No.

The move has proven neither severe enough nor long-lasting enough to ensure slower growth ahead. In fact, in order to signal even a 30% chance of recession four quarters out, the 10-3 spread would have to (a) dip into negative territory and (b) remain there for three months. (See this New York Fed

piece for details about the slope of the yield curve as a predictor of growth.)

Keep the 1998-1999 experience in mind. The 10-3 spread held between 92 and 30 bp for 11 months through August 1998 and then troughed at 7 bp in September. This had many forecasters

predicting capital-spending slowdowns and consumption slowdowns and growth rates with 1-handles; it also had them thinking that the central bank that was about to embark on an aggressive easing policy.

Those turned out to be precisely the wrong calls.

Are real (inflation-adjusted) interest rates now high enough to slow the economy?

No.

Not even close.

Consider the following matrix of real-rate calculations: The 30-year bond, the 10-year note, and the federal funds rate, all adjusted by both an overall and a core (excluding food and energy) price index.

Of these six measures, the funds rate adjusted by the core consumer price index has shown the most upside movement since policymakers began tightening last June: It's up 94 bp as of February (the latest month for which price data are available). It's risen to 3.62% from 2.68%.

Now consider the 1994 experience, when policymakers had to force the real funds rate higher by almost 300 bp -- to 3.03% from 0.11% -- over the course of just 14 months in order to slow the economic growth rate by 1.3 percentage points.

This is the light in which the one-or-two-more-hikes-and-then-out calls seem most ridiculous: The economy is growing faster now than it was then, and cycle-to-date rate increases have proven much kinder. Yet many market participants still seem to believe that (a) the central bank has just about finished its work and (b) the action we've seen thus far (along with the move we'll see in May) will serve to sow serious slowdown seed.

Uh-uh. No.

What's it gonna take?

The economists at Goldman put forth the following observation in a research note last week.

According to the conventional view of monetary policy, Fed tightening takes about a year to slow the economy. For example, in the Fed's econometric model FRB/US, 125 basis points of tightening push real GDP growth down by about 3/4 percentage point after one year. On this basis, one might think that the Fed's tightening effort so far should push real GDP growth (on a fourth quarter/fourth quarter basis) from 4 1/2% in 1999 to 3 3/4% in 2000, not far from the Fed's estimate of sustainable growth.

But this reasoning has one fatal flaw. Since nobody outside the banking sector borrows at the federal funds rate, Fed tightening only affects the real economy if it first tightens financial conditions. Thus, a higher federal funds rate must feed through to other financial variables that then restrain real economic activity. For example, in the FRB/US model, a higher federal funds rate slows the economy only because, on average, it raises market interest rates, strengthens the dollar, and pushes down equity prices. But when these conditions are not fulfilled -- such as now -- then even a rise in the federal funds rate to 100% will not slow the economy, neither in the model nor in the real world.

Along somewhat similar lines, Stephen Roach makes the following point in a recent

Barron's

piece.

The way out of the Fed's moral hazard dilemma requires a major tactical adjustment on the part of the central bank -- moving away from reliance on one blunt policy instrument (the federal funds rate) and embracing nontraditional remedies that are targeted more at the excesses of the stock market and its concomitant wealth effect. There are a number of nontraditional options the Fed has at its disposal. At the top of my list would be an increase in margin requirements -- something the central bank hasn't done in 26 years. ... While the Fed remains firmly on record against such an action, arguing that it would discriminate against individual investors, the emerging excesses of margin debt argue for a serious rethinking. ... Market intervention doesn't sit well with me. But the alternative is far less appealing. A blunt policy instrument such as the federal-funds rate simply won't do the trick in the New Economy.

Leave aside the issue of whether shares should or shouldn't be part of the central bank's equation; policymakers have already stressed to us that they ARE, and so those are the parameters within which we all have to work. And don't take away from these quotes that the funds rate could quadruple overnight and still not make the economy do what the Fed wants it to do.

That isn't the point at all: As Roach rightly notes, "Eventually, the blunt-instrument approach will take a toll." The point, rather, is that because the gophers the Feds are smashing keep popping back up -- because the device they're using to bash them has rendered them somewhat impotent -- they're going to have to work even harder to get the job done. Put simply, the funds rate is going to have to get higher than most folks think.

How high?

Paul Kasriel, one of the first-rate economists around, doesn't claim to know precisely -- but he does know it's higher than this. He figures that rates need to get to a point where they bite into income growth materially enough to put a notable dent in household balance sheets (which currently look fantastic). At that point debt burdens will become more oppressive and the postwar high in debt-to-asset ratios for nonfinancial corporations we see now will become more problematic -- only then will the real slowing begin. (Note that disposable income growth is on track to accelerate between the fourth quarter and the first. Fresh figures will be released on Friday, and we will write them up then.) Diane Swonk, another of the few truly solid thinkers and researchers in the profession, reckons that the nominal funds rate might have to get to double digits before everything's said and done.

Epilogue (or Let It All Hang Out)

What do YOU make of all this?

Your narrator is convinced (as convinced as anyone can be about things like this) of two things.

(a) The bond has entered a secular bull market.

(b) The economy is likely to keep growing at (on average) a 4% rate (and perhaps more) through the remainder of the year.

How to sell this? What's the fundamental story that brings together a Fed that continues to tighten and an economy that continues to roar and a bond yield that continues to fall?

Maybe there doesn't exist a fully cogent one. Maybe the bond is now so disconnected from everything else, so living in a world of its own (and likely to stay there), that what's going on with the economy and the Fed just don't matter anymore.

Or maybe there does. Maybe the Fed ends up engineering (either through skill or luck or a combination of both) the perfect landing. Maybe good and better news on the productivity front keeps inflation expectations in check. Maybe the money numbers turned soon enough to avoid a serious price problem. Maybe shares suffer a material setback -- enough of one to send loads of money to Treasuries, but not enough of one to wreck things completely.

Whatever. There are two plays here. One is to get into the bond if you haven't already. Two is to take the other side of anything predicated on the notion that the economy's gonna slow meaningfully and permanently anytime soon.

Act on them if you agree with (a) and (b).

Fade them if you don't.

P.S.

Many thanks to Kasriel and Swonk (on the economics side) and to Grauer and Pianin (on the bond side) for valuable contributions to this piece.