As Fed Holds Rates Down, Investors Face Tough Choice

Imagine you’re on a train that’s taking you toward somewhere you really want to be. Imagine also that you’re clairvoyant, and you know the train will wreck at some point -- you just don’t know exactly when.

Do you stay on the train for as long as you can, hoping to jump off just before the wreck?

That, in essence, is the question that faces big and small investors alike this year as they debate what the Federal Reserve may do with interest rate policy, when it will do it and how a Fed shift could affect financial markets.

Central bank policymakers will meet Tuesday and Wednesday, their first gathering in the new year. It’s virtually certain they will hold the target level for their key short-term interest rate at a generational low of 1%, which is where it has been since June.

But everyone knows that, barring unforeseen calamity, the Fed can’t keep rates at this level forever. If the economy continues to improve, Chairman Alan Greenspan and his cohorts eventually will have to tighten credit.

And when they do, that’s when the train wreck occurs, many investors fear. Though it’s true that the Fed has tweaked interest rates countless times over the last century without causing catastrophe, the concern this time is that the economy, and financial markets, may be so addicted to rock-bottom rates that any upturn would trigger panic selling on Wall Street, slam the housing market and cause many other unpleasant side effects.

Just looking at stock and bond markets worldwide this year, however, you wouldn’t know there’s potential trouble on the horizon. Stocks overall have continued to rally after last year’s strong advance. Despite some mild profit taking in the U.S. market last week, the Standard & Poor’s 500 index is up 2.7% since Dec. 31. Many other key indexes have posted bigger gains.

In the bond market, the yield on the 10-year Treasury note, a benchmark for other long-term interest rates, ended at 4.07% on Friday, down from 4.25% at year’s end.

The markets are doing well in large part because the Fed keeps saying, “Don’t worry about us for now.” Greenspan and other Fed officials have gone out of their way in recent weeks to reiterate that they don’t see a compelling reason to raise interest rates soon.

The phrasing the central bank has used in its post-meeting statements in recent months is “considerable period” -- as in, “With inflation quite low and resource use slack, the committee believes that policy accommodation can be maintained for a considerable period.” (That’s what they said in December.)

As for this week’s meeting, the only issue is whether the wording of the final statement will be changed. Most economists believe the Fed wants to keep business, consumers and Wall Street from suddenly thinking that a rate increase is imminent. So if policymakers drop “considerable period,” they will have to come up with some other phrasing that gets the same point across, many analysts say.

“The main question [for the Fed] ... will be how to say that they are not changing interest rates, and see little likelihood of doing so in the foreseeable future, in a way that minimizes the chances of misinterpretation by the financial markets,” brokerage Goldman Sachs & Co. told clients in a report Friday.

But therein lies the problem, Fed critics say: The longer Greenspan encourages investors to get on the rally train in stocks and bonds, the worse the wreck may be when the central bank finally begins to tighten credit even modestly.

Given the economy’s rebound over the last year, “The Fed is holding rates way below where they’re supposed to be,” John Ryding, chief market economist at brokerage Bear Stearns & Co. in New York, told a gathering of members of the Los Angeles Society of Financial Analysts last week.

Ryding isn’t alone in that assertion. The bond market also seems to believe that short-term rates, which are what the Fed controls, are out of whack. That can be seen from the level of longer-term rates, such as on the 10-year T-note.

The Fed influences long-term rates, but the marketplace sets them. Though the 10-year T-note yield has pulled back in recent months, it’s far above the lows reached in June, when the economy’s recovery still was a question mark.

The result is that the gulf between short-term and long-term interest rates is extraordinarily wide. And that phenomenon feeds on itself: A slick way to make money today, if you’re a professional bond investor, is to borrow short-term at 1% and invest the money in long-term bonds that pay 4%. Your return: 3%. That’s called the “carry trade.”

The risk there is obvious. Once short-term rates begin to rise, the profit spread will shrink, and those investors will rush to dump their long-term bonds, which would put upward pressure on long-term yields.

By keeping short-term rates so depressed, the Fed also encourages investors to bet on stocks, of course -- and to buy homes, gold and anything else that might produce a better return than the miserable yields on short-term cash accounts.

Low interest rates also make some foreign investors less interested in buying U.S. bonds. That has helped drive the dollar down over the last year.

The dollar’s weakness now is reaching a point of concern for major U.S. trade partners, because it makes it tougher for foreign companies to compete with their U.S. rivals. The Bush administration has been happy about this because American companies are gleeful.

But other nations are taking a page from the Fed’s book. Last week, the Bank of Canada cut its key short-term interest rate to 2.5% from 2.75%, citing dollar issues. By Friday, there were rumors that the European Central Bank also might resort to a rate cut to weaken the euro.

What’s wrong with flooding the world with cheap money? If you recall from Economics 101, the main risk in keeping credit loose for too long is that it can fuel inflation down the road. And higher inflation could be devastating for financial markets.

Why would the Fed want to risk higher inflation? Its harshest detractors say the central bank is holding rates down -- and the stock and housing markets up -- to assure that President Bush gets reelected.

Others say the Fed simply is overly worried that the economic recovery might fade, and is erring on the side of stoking inflation rather than risk another slowdown and the specter of deflation, or falling prices.

But there also are many people who believe the Fed is entirely justified in keeping short-term interest rates at these four-decade lows.

“The Fed is doing exactly the right thing,” James Glassman, senior economist at J.P. Morgan Securities in New York, told the Los Angeles analysts’ gathering last week. “You floor the accelerator” until the economy’s rebound begins to show substantial job creation, he said.

Jobs have been the missing element of this recovery, but Glassman and other optimists believe it’s only a matter of time before hiring picks up.

Until then, the Fed should stand pat, said Steven Wieting, economist at Citigroup Global Markets in New York.

Inflation, at least as measured by the consumer price index, remains near generational lows just like short-term interest rates, Wieting said. The relative absence of inflation, along with the meager job gains of the last few months, means the Fed would risk a public firestorm if it tried to raise rates, he said.

Bearish investors may not like what’s going on in financial markets, but “monetary policy is not conducted just for financial markets, but for the real economy,” Wieting said.

Investors are right to be concerned about a market backlash when the Fed eventually raises rates. But until then -- and not even the Fed may know when “then” is -- the message of the markets is that you risk leaving a lot of money on the table by leaving the game now.

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Tom Petruno can be reached at tom.petruno@latimes.com.