Wednesday, August 23, 2006
American Notebook by Gerard Baker
ROBERT RUBIN, of sainted memory, famed the world over as the super-competent Treasury Secretary of the United States under President Clinton, had a less famous and rather unorthodox view about economic policy.
He never believed much in the power of central banks. A lifetime of experience in financial markets had taught him, he used to say, that monetary policy matters much less than the bond market in determining how the economy performs. It is long-term interest rates, the outcome of investment decisions by tens of thousands of bond traders, not votes by government officials in marbled buildings, that really determine the fluctuating monetary conditions that allow the economy to expand or contract.
The Rubin view has quite a wide following in both financial and academic economic circles. Though few would go as far as Saint Bob in arguing that central banks are virtually redundant, many agree that efficient bond markets, acting minute by minute on the basis of billions of pieces of data, do a vital job.
Bond market “vigilantes”, on this view, detect the first hint of inflationary developments in the global economy and then, by selling official and unofficial debt, push prices down and interest rates up. Similarly, when the merest hint of recession or deflation is in the air, they buy up fixed-income assets and push down interest rates, thereby helping to avert the threatened danger.
But how well are these bond market vigilantes performing right now? Ten-year bond yields in the United States have dropped sharply in the past month — yesterday in mid-morning New York trading the ten-year Treasury was yielding a smidge below 4.83 per cent. That is down from 5.24 per cent six weeks ago. That may not sound a like a big move, but in both scale and direction it is highly significant. It says the bond market has decided that the inflation scare that had us all gripped a few weeks ago is over and that the bigger threat is now a slump. That view is magnified by the current inversion of the traditional upward-sloping yield curve — ten-year yields are now almost half a percentage point below the overnight (official) federal funds rate.
Equity traders have taken their cue from the bond vigilantes, focused on the diminished risk from inflation and marked prices sharply higher.
Can this be right?
Last week’s consumer price and producer price indices were certainly bond market-friendly, suggesting that price pressures are weaker than previously feared. But prices in the US generally are still rising at between 2.8 and 4.5 per cent, depending on which measure you use. That clearly does not support the optimism of the credit markets. The last time that inflation broke out to these levels, in the early 1990s, bond yields were over 8 per cent.
The bond market vigilantes, in fact, seem to be following rather than leading. They appear to have taken their cue from the policymakers — buying aggressively into the Federal Reserve’s optimism that inflation is contained. That raises serious questions about whether these vital guardians of the currency are quite as independent and forward-looking as they are supposed to be. What’s the point of a private vigilante if he simply does what he is told by the authorities? As the ever-thoughtful Peter Schiff, of Euro Pacific Capital (www.europac.net), points out, the most interesting aspect of all this is that not all financial market participants have interpreted the recent data in the same way.
Since mid-July, the dollar has fallen by 3 per cent against the pound, 2.5 per cent against the euro and just under 2 per cent against the Japanese yen. Of course, part of this might simply reflect a marking down of the US currency in line with changed expectations about the next move in rates since the Fed paused in its rate-rise campaign two weeks ago.
But most of the decline in the dollar took place before that Fed meeting — at a time when further central bank rate increases seemed more likely than they do now. A more probable explanation is that foreign exchange traders have become more nervous about US inflation and its effect on the attractiveness of US assets.
Which would suggest that the currency market’s posse of vigilantes may be more alert to what is going on than their slightly somnolent colleagues in the bond markets.
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