What's Behind the Interest Rate Conundrum?
In his testimony on June 9, 2005, before the Joint Economic Committee of the US Congress, Fed Chairman Alan Greenspan has again raised the issue of the divergence between the federal funds rate and long-term rates.
Alan Greenspan views this divergence as a puzzle. At the end of May the yield on the 10-year Treasury-Note stood at 4%—well below the 4.6% recorded in June last year when the Fed embarked on its tighter interest rate stance. Moreover, the yield on Moody's long-term Aaa Corporate Bonds fell to around 5% at the end of May from 6% in June 2004.
According to Greenspan,
With a firming of monetary policy by the Federal Reserve widely expected, they (market participants) built large short positions in long-term debt instruments in anticipation of the increase in bond yields that has been historically associated with a rising federal funds rate. But by summer, pressures emerged in the marketplace that drove long-term rates back down.1
Note that Greenspan blames some mysterious 'pressures' for the divergence between the federal funds rate and long-term rates. Careful examination of this however, shows that there is no mystery. The mysterious pressure is in fact the outcome of the Fed's own policies.
What matters for the determination of interest rates is monetary liquidity, or excess money, and not the interest rate stance of the Fed as such. For instance, in order to maintain a given interest rate target in the midst of strong economic activity the Fed may be forced to push more money into the system to prevent the fed funds rate from surpassing the target. This in turn will prevent a fall in the growth momentum of liquidity.
Conversely, on account of weak economic activity, in order to prevent the rate falling below its target the Fed will be forced to take money from the system. (It must be realized that when Fed officials set their target they don't really know what is taking place in the economy although they might wish to give the impression that they are supposedly navigating the economy in the right direction).
In this regard since June 2004, despite raising the fed-funds rate target, the Fed has actually lifted the pace of pumping money into the system. Thus the yearly rate of growth of the Fed's balance sheet—Fed Credit—rose from 4.5% in June 2004 to 7% in November of the same year. Since then the rate of growth has stood at around 6%. In short, the Fed has been talking tough while acting loose.
What we observe at present is the outcome of the massive lowering of the fed funds rate target from 6.5% in early January 2001 to 1% in June 2003, and which was kept at 1% until June 2004. This massive reduction of the interest rate target has generated strong economic stimulus, which has so far rendered the tight interest rate stance ineffective as far as liquidity is concerned.
The main reason for this is the existence of the time lag between changes in interest rate policy and its effect on economic activity. We have estimated that the average time lag between changes in the fed funds rate target and the growth momentum of industrial production is on average 12 months. Hence at the time of the adoption of a tighter stance in June 2004 the effect of the previous easy interest rate stance was gaining pace (see chart).
Since June 2004, the yearly rate of growth of industrial production has hovered at around 4.5%. Obviously, the small incremental rises in the fed funds rate target against the background of strong economic activity have made these targets not sustainable—the Fed had to lift its monetary pumping to prevent the fed funds rate overshooting the target. This monetary pumping has in turn prevented the growth momentum of liquidity from falling thereby preventing a rise in long-term interest rates.
Observe that in order to attain a given federal funds rate target the US central bank must constantly manage the flow of money to financial markets. The fluctuations in monetary injections that are involved in achieving the federal funds rate target have a direct effect on the growth momentum of money, which in turn (with a time lag) affects fluctuations in so-called economic activity. (Note that on account of the time lags between the Fed's monetary injections and economic activity, central bank policy makers in fact react to the symptoms of their own past policies. They are 'chasing their own tail').
It is quite possible that the Fed may decide to push the fed funds rate higher in order for liquidity growth momentum to start trending down. By doing this the Fed will set in motion a depressing effect on economic activity some time in the future—more than likely in 12 months or so time. In the meantime the lagged effect of the tighter interest since June 2004 is likely to start to undermine various activities that sprang-up on the back of past loose liquidity thereby setting in motion an economic bust.
Frank Shostak is an adjunct scholar of the Mises Institute and a frequent contributor to Mises.org. Send him MAIL and see his outstanding Mises.org Daily Articles Archive. Comment on this article on the Mises Economics Blog.
- 1. Greenspan, Alan. United States Congress, Joint Economic Committee of the US Congress. Testimony; June 9, 2005.