Mocking the Maestro

Alan Greenspan and the Fed still think inflation's a major concern -- bond investors beg to differ.

May 4, 2005: 4:30 PM EDT
By Paul R. La Monica, CNN/Money senior writer

NEW YORK (CNN/Money) – How many more interest rate hikes are in the cards this year?

That's hard to answer since it depends on whether you're listening to the Federal Reserve or to the bond market. And they don't seem to be talking the same language right now.

The Fed, which boosted interest rates by a quarter-point for the eighth consecutive time on Tuesday, keeps indicating it's worried about inflation and that it's going to keep raising rates at a measured pace to combat it.

The central bank did say, though, in its corrected statement issued late in the afternoon, that longer-term inflation expectations remain "well contained."

But bond investors seem to be more focused on the economy's recent slowdown than on inflation. The yield on the 10-year Treasury note remains well below where it was before the Fed started hiking short-term rates last year, even though Alan Greenspan and other Fed members have said that was a "conundrum."

In effect, Mr. Bond Market is putting his hands over his ears and shouting, "I'm not listening! I'm not listening!" whenever the Fed discusses inflation. (Well, there is that old joke in the fixed-income market that the main difference between bond traders and bonds is that bonds mature.)

So who's right?

The inflation argument
Inflation hawks note that even though the Fed has raised the fed funds rate by 2 full percentage points since June, it is still at the relatively low level of 3 percent. And with oil prices remaining high, inflation is something to worry about.

So even though the economy hit a soft patch in March, the Fed still has room to raise interest rates before it reaches the magic "neutral" level meant to keep the economy growing at a decent pace without prompting inflation.

"There is no operating manual that says what a neutral fed funds rate is, but the Fed knows that it's higher than 3 percent," said Mark Vitner, senior economist with Wachovia Corp.

As such, Vitner says, the Fed may raise rates four more times this year to raise the fed funds rate to 4 percent. The Fed is scheduled to meet five more times this year. Its next meeting lasts for two days in late June, with an announcement about interest rates due on June 30.

David Wyss, chief economist at Standard & Poor's, thinks the Fed could keep raising rates until they're about 4 or 4.5 percent. He argues that would not only fight inflation but also give the central bank more room to lower rates in case the economy weakens further.

"Using the analogy of the Fed driving a car, at 1 percent the Fed was driving with the accelerator pinned to the floorboard and that's not a good way to drive when you're turning a corner. Raising rates gives them more flexibility," said Wyss.

The slowdown argument
Still, bond investors have legitimate reasons to be more worried about a slowdown than inflation. For one, many say inflation readings tell you more about the past and are not helpful in predicting where the economy is heading.

And the economy grew at a the slowest rate in two years in the first quarter as oil prices took a toll on spending.

"The problem with the Fed's focus on inflation is that it's really a lagging indicator. What you need to do is gauge what demand will be like down the road in order to determine future prices. And the bond market is focused on slowing growth," said Tom Higgins, chief economist with Payden & Rygel, an asset management firm in Los Angeles.

Of course, the number and magnitude of future rate hikes really depends on the next economic numbers. Friday's jobs report for April will be key for signs of inflation. Economists expect an addition of 175,000 jobs.

The major knock some market observers have on the Fed: job growth remains tepid at best, and hourly wages are not growing nearly enough to fuel inflation.

"I don't see inflation as a big deal in the classic sense. There are no wage pressures and no cost overruns. We're seeing inflation mainly in the price of gas and other commodities," said Paul Nolte, director of investments of Hinsdale Associates, a money management firm based in Hinsdale, Ill.

And if the economy stays sluggish in the second quarter, say gross domestic product (GDP) growth of 3 percent or less, that may prove bond investors right -- and spur the Fed to reconsider its measured stance on rate hikes.

The legacy effect?
Finally, the debate over why the Fed is raising rates in the first place. Sure, short-term rates were artificially low, so the Fed's trying to drive up rates to shake excess liquidity out of the economy.

But there's also the matter of Greenspan's legacy. His tenure as Fed chairman ends next January and several analysts said Greenspan would prefer to err on the side of caution -- and keep raising rates to ensure inflation doesn't make an ugly comeback -- even if it means sacrificing a bit of economic growth.

"The Fed has a three-pronged mandate. The first is price stability and that's probably the most important," said Payden & Rygel's Higgins. "Given how hard the Fed fought to get inflation down in the 1980s, Greenspan doesn't want to be the guy who let it back out of the box."

Still, others think Greenspan shouldn't go overboard to fight what some see as a phantom threat.

"Greenspan is not going to wake up in June of next year and say 'I should have really raised rates more aggressively.' His legacy of price stability is pretty secure so I don't think the last six months of his tenure will destroy it for him," said Hinsdale's Nolte.