Alan Greenspan left out one little word in his testimony to Congress this week: "measured."
What does this mean? It's hard to say for certain right now. We aren't even totally sure what the word itself means for policy, much less what it means when the word is left out of the discussion.
Since the Fed started using the word "measured" in its press releases several months ago, I have interpreted it to mean the following. The fed funds rate will be raised 25 basis points at a time in a series of meetings over the next 18 to 24 months with occasional breaks in the increases. Since then, there has not been such a break. Every meeting since mid-summer has resulted in a 25 b.p. increase. If you would have asked me in June if we would have had a meeting between then and now that left rates unchanged, I would have said yes. I would have been wrong. And yet, in the days leading up to each meeting, I have correctly predicted that rates would go up. Clearly the preponderance of the news since June has been positive. Not enough to please everyone, but enough to render my June definition of "measured" a bit out of step with reality.
So count me as rather unsurprised that Greenspan ditched the word. Maybe it was the right word in June, but no longer. Or maybe the word doesn't mean the same thing anymore.
Today, the markets are expecting rate increases at the next three meetings. The IEM is only looking at the next two, and it agrees. Who am I to disagree? In the absence of any developments between now and then, I think the next two, and quite likely three, are almost a foregone conclusion. After that? Ask again later.
And yet, the long bonds show no fear. Yield on the 10 year is still below 4.2%. In June, I told our local media that such a result would be possible if the financial market believed the Fed was resolute in fighting inflation. After all, in June, there was some upward pressure building on yields as the markets started to turn bearish. I kept repeating that for the remainder of 2004 as I tried to explain the apparent paradox. I still think that my explanation was right for the 3rd and maybe the 4th quarter, but I told people that I would expect to see a little steam coming out of the bond market by the end of the year or early 2005. I'll give myself partial credit on this one. I wouldn't have predicted the yield to be this low in mid-Feburary.
Conventional wisdom would say that the 10 year yield has to start to move up by the time the Fed finally reaches a "neutral" policy stance, whatever that turns out to be. Is this odd situation we find ourselves in due to the fact that foreign central banks are soaking up any bonds we put out there? Brad Setser seems to think so, and it has him worried. However, I think the negative scenario he paints needs a catalyst to get it started. It's unclear precisely what that catalyst might be. (If it was clear, this post, as well as many others on my favorite econ blogs lately, would be unnecessary.) Setser has a rather general hypothesis that should provide us with a good amount of blog fodder.
The current system is delivering rapid growth in China. But that does not mean that the current system does not also impose substantial costs on China. Over the next two years, Nouriel and I suspect those costs will become increasingly apparent, and China's willingness to continue to "overfinance" the US will fall -- forcing the US to start to adjust ...
Obviously, that is a debatable proposition, but given its importance to the global economy, it also something worth debating!
Indeed.
And so, a post that began with the observation that Greenspan failed to say a certain word ends with the speculation that something very critical lies beneath the surface of that story. Interest rates may need to go higher to get foreign private investors to carry the load now being borne by foreign central banks. How high? What is "neutral"? Is neutral enough? These are questions that no one can answer right now, but as Setser indicates, this is an important debate.
For more, see Reuters and the Washington Post, just to name a couple of today's stories. This isn't going away.