Fed talks tough -- and hopes that does the trick Fed hopes warning is all that’s needed
Repeat something enough and people might actually begin to believe it’s true.
So it went this week with Federal Reserve Chairman Ben S. Bernanke and his cohorts at the central bank.
They made clear that inflation is their primary worry at the moment, and that they’re ready to raise interest rates if that’s what it takes to subdue price pressures.
Raise interest rates? Could this be the same Fed that slashed its key short-term rate from 4.25% to 2% between January and April in a drastic attempt to keep the financial system from melting down?
Mission accomplished?
The turnabout in the Fed’s tone has been building for weeks, but Bernanke, nicknamed Gentle Ben, on Monday issued a warning that was as tough-sounding as he could muster.
The continuing surge in energy prices “has added to the upside risks to inflation and inflation expectations,” he said in a speech. The Fed, he added, “will strongly resist an erosion of longer-term inflation expectations.”
“Strongly resist” could mean only one thing: a rate hike.
The Fed’s Philadelphia bank president, Charles Plosser, was more direct. He told CNBC on Thursday that the Fed would have to “act preemptively” to damp inflation.
Central bank officials now have talked enough about a possible credit-tightening move that bond investors, at least, believe them.
Consider: A week ago the annualized yield on two-year Treasury notes was 2.38%, not much above the Fed’s benchmark rate of 2%.
By the close of trading on Friday, the two-year T-note yield was 3.02%, a stunning jump of 0.64 of a percentage point in five trading days.
Investors suddenly demanded higher yields to compensate for two risks: first, that the Fed would raise its own rate sooner rather than later, putting a higher floor under all interest rates; and second, that maybe inflation really was a bigger problem than the bond market had assumed.
For bond owners, inflation is Public Enemy No. 1 because it erodes their fixed-rate returns over time.
On Friday, the government’s report on May consumer inflation was ostensibly good news. Although the overall consumer price index rose 0.6% last month, the so-called core index (excluding food and energy costs) was relatively tame, up 0.2%. That left the overall inflation rate at 4.2% over the last 12 months and the core rate at 2.3%.
In theory, the lower core figure suggests that the surge in energy and food costs isn’t spilling into other goods and services. Yet that failed to bring buyers pouring back into bonds Friday.
Instead, market yields on most Treasury issues continued to rise. The 10-year T-note yield ended the day at 4.26%, up from 4.21% on Thursday and the highest since Dec. 26.
Could the Fed have done too good a job of scaring bond investors? Maybe. Or perhaps that’s part of the plan.
There are many on Wall Street who believe Bernanke is just saber-rattling.
It was only a week ago, after all, that the government dropped a bomb on the stock market in the form of the May employment report, which showed a surge in the jobless rate to 5.5% from 5% in April.
That’s hardly the normal backdrop for a credit-tightening move by the Fed.
By talking tough, however, the Fed can hope to preserve its inflation-fighting credibility. And if that jawboning pushes up market interest rates, the Fed, in effect, tightens credit without formally doing so. In other words, Bernanke lets the bond market do his dirty work.
But the drag effect on the economy still is the same, and that’s the risk. Treasury bond yields aren’t rising in a vacuum. The average rate for 30-year conventional mortgages jumped to 6.32% this week, up from 6.09% a week earlier and the highest since late October.
And the average yield on corporate junk bonds ended this week at 9.47%, up from a recent low of 9% on May 2.
Higher borrowing costs are the last thing the housing market and the financial system need today. Note the 20% dive in shares of brokerage Lehman Bros. this week after it warned it would report a $2.8-billion loss for its latest fiscal quarter.
There’s little doubt that the Fed would prefer to hold interest rates down at least through the end of this year.
But policymakers could be pushed by factors beyond their control. For one, other central banks around the globe already are tightening credit to fight inflation. And the European Central Bank is threatening to do so in July.
If foreign interest rates continue to rise and the Fed stands still, it risks an outflow of money from U.S. bonds as investors look for better returns elsewhere. That could send the dollar into a new spiral, after a recent surprising rally in the greenback’s value.
What’s clear is that the mess in the U.S. financial system, at a time of fearsome inflation pressures from energy and food costs, has left the Fed in a serious pickle. Bernanke & Co. are hoping they only have to talk the talk on inflation -- and not walk the walk.
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