Federal Open Market Committee is poised to raise interest rates
for the seventh time since June, but this time it's a little different.
While the Fed may be acting on short-term interest rates, their
words are now aimed at long-term interest rates. As a result, the
impact of Fed policy is reaching beyond credit cards, home equity
lines and short-term CDs. The focus is shifting to what the Fed's
influence might be on long-term interest rates that govern much
of the mortgage market.
For much of the past nine months, the Fed had
the best of both worlds -- moderate inflation readings meant there
was no pressure to depart from the "measured" pace of
quarter-point moves, while there was no fear of an economic slowdown
from a sharp increase in long-term interest rates. As testament,
the five-month period from September to early February showed virtually
no movement in mortgage rates, with the average 30-year fixed rate
fluctuating between 5.59 percent and 5.85 percent. All the while,
the Fed was raising short-term interest rates at every opportunity.
So when did the focus shift from
short-term interest rates to longer-term interest rates? The about-face
began with several well-placed comments by Alan Greenspan in prepared
testimony before Congress beginning Feb. 16. In reference to the
puzzling decline in long-term rates amid consistent Fed rate increases,
Greenspan termed it a "conundrum" and postulated it may
be a "short-term aberration." Of course, in clever Greenspan
fashion, the words never actually crossed his lips. While included
as part of the official record, he self-edited these comments from
his verbal remarks to prevent sound bites being replayed on every
newscast worldwide. Nonetheless, the message was delivered.
Such comments are to the bond and mortgage markets
what his famed "irrational exuberance" quip was intended
to be for a buoyant stock market in 1996. Witness the impact. Yields
on 10-year Treasury notes have increased from 4.1 percent to 4.52
percent since, with the average 30-year fixed-rate mortgage jumping
from 5.59 percent to 6 percent in the same time period.
In a speech March 8, Fed governor Ben Bernanke stipulated
two conditions under which the Fed will stop raising interest rates
-- and one is the level of long-term interest rates relative to
short-term rates. If that isn't a message to the markets that long-term
interest can and will rise from present levels, what is? How else
can the Fed deliver the message short of posting a blinking neon
marquee in Times Square?
Another matter is whether the Fed will drop the word
"measured" from its post-meeting statement. In the same
March 8 speech, Bernanke mentioned that "this language was
always meant to convey a policy forecast, not a policy commitment."
While at first glance this may appear to pertain only to the movement
of short-term interest rates, the message is also aimed at longer-term
security holders. Dropping hints now that the Fed may need to act
more aggressively at some point is warranted so the bond market
doesn't go ballistic if it eventually happens.
Twice in the past four months, Alan Greenspan has
mentioned the ballooning current account deficit and that foreign
investors will eventually diversify away from the falling U.S. dollar.
Such a scenario would cause interest rates to rise, especially on
long-term securities, and Greenspan's gentle reminder is an additional
note of caution to the bond and mortgage markets.
The effect of this "open mouth" policy goes
beyond that seen on fixed mortgage rates, as mentioned earlier,
and also translates into higher yields on long-term certificates
of deposit. After remaining at a virtual standstill for much of
the first two months of 2005, the average five-year CD yield has
perked up in recent weeks, climbing from 3.59 percent before Greenspan's
Congressional testimony to 3.67 percent now.
While the tendency may be to think of another
interest rate hike as the "same old story," the moves
made now and in the coming months will be more significant across
the entire spectrum of interest rates than any rate moves seen thus