New Fed Talkativeness Lets Markets Do the Work on Rates

In the last few weeks, the annual interest costs on a typical mortgage in Valencia have risen $700. The amount that Beverly Hills-based Hilton Hotels has to pay to borrow $10 million has climbed tens of thousands of dollars.

The reason, more than any other, is the Federal Reserve. And what has the Fed done? Talked.

Indeed, the institution that once believed the only way to manage America’s economy was to keep its mouth shut is now engaged in a veritable gabfest.

The change is of such monumental proportions that it almost constitutes a new kind of economic policy. Where once the Fed used traditional tools such as raising or lowering interest rates, it now administers a “virtual” policy of making speeches and issuing news releases to nudge the economy up or down.

“The Fed has totally changed its operating procedures,” said Allan Meltzer, a political economist at Carnegie-Mellon University in Pittsburgh who is writing a history of the central bank. “They have gone from Sphinx-like silence to a rising crescendo of noise.”

Driving the Fed is a confluence of forces, chief among them a fear that any abrupt policy shift could topple the sky-high stock market from its lofty perch.

The dimensions of the change are apparent in matters small and large.

One small example: Fed Chairman Alan Greenspan makes fewer jokes about his ability to leave listeners befuddled. The man who once described his job as “mumbling with great incoherence” has been much less obscure in recent speeches.

A larger example: Economists, investors and analysts who make a living keeping tabs on the Fed now actually know when it changes policy.

After meetings of the central bank’s policymaking committee, said Lynn Reaser, chief economist for Bank of America’s private bank in Jacksonville, Fla., “it used to take us days to figure out what they were doing. Now we find out at precisely 2:15 p.m.,” when the Fed announces results of the committee meeting.

The latest announcement Tuesday represented a high-water mark in the Fed’s campaign of openness. Instead of waiting until it actually changed rates to say something, the central bank issued a news release based on what was, in effect, a change of heart.

The Fed said it had become so “concerned about the potential for a buildup of inflationary imbalances” in the economy that it was leaning toward raising rates sometime in the coming months.

The release followed weeks of speeches by senior Fed officials, including Greenspan, that also warned about inflation’s persistent danger.

The combination has had largely the effect that analysts say the central bank was seeking: Bond buyers are demanding higher interest rates from sellers to protect against the possibility of higher inflation. The yield on a high-quality, 10-year corporate bond rose almost half a percentage point from mid-April to Friday, according to Merrill Lynch.

And the warnings persuaded mortgage lenders to do the same with home buyers. The average interest rate on a 30-year, fixed-rate mortgage climbed from 6.87% in late April to 7.23% Thursday, according to the Federal Home Loan Mortgage Corp.

As a result, “the market is doing the Fed’s work for it,” said David M. Jones, a veteran Fed watcher as chief economist for the investment firm Aubrey G. Lanston & Co.

“The best way to cope with the threat of inflation is to slow the economy by increasing the cost of credit for consumers and businesses,” said Jones. “That’s what the Fed has done, and it’s done it merely by talking.”

At least so far.

Jones and other analysts emphasize that there are limits to the central bank’s practice of “virtual” policy. Just as a labor union must occasionally go on strike to make a strike threat believable, only by maintaining a credible threat that it might actually raise interest rates can the Fed move markets merely on its say-so.

Indeed, there were some signs late last week that the central bank may have to act on its own sooner than it had hoped. Market interest rates on the 30-year U.S. Treasury bond, which had been rising on inflation worries for more than a month, actually fell back slightly after the Fed’s Tuesday announcement.

“That can’t be what they wanted,” said Tony Crescenzi, chief bond market strategist for Miller Tabak Hirsch & Co. in New York. “If it keeps up, they’ll have to change rates on their own.”

Even when the Fed has actually changed rates recently, rather than just talked, there has been a “virtual” quality to its action.

Last year, when it cut short-term interest rates three times in as many months in response to the near-panic in global financial markets, the effect was almost instantaneous, contradicting conventional theory which assumes that rate cuts need months or years to have an effect.

“The real economic reasons for cutting were not nearly as important as the market-calming psychological ones,” said Lawrence B. Lindsey, a former Fed governor and now a senior fellow at the American Enterprise Institute.

The Fed’s increasing eagerness to explain itself is being forced on the central bank, first and foremost by the mounting importance of the nation’s ever-rising stock market, which now represents a far larger fraction of American household wealth than ever and a bigger role in their spending decisions.

The Fed, analysts said, has gone out of its way to avoid repeating the experience of Japan, whose ham-handed efforts to tame a booming economy and stock market resulted in a nearly decade-long slump.

Fed nervousness about sending the market into a tailspin is palpable in virtually all of its deliberations.

Minutes of the March meeting of its policymaking board, which were released last week, show that even back then members believed the central bank would soon have to raise interest rates. But they stopped short of doing even what they did Tuesday--announcing that they were tilting in favor of a rate hike--for fear of a “relatively pronounced and undesirable effect on financial markets.”

Speeches and news releases “give the Fed a nuanced way to affect the economy, and they feel they need that because they’re in a delicate situation,” Lindsey said. “They want to control the bubble; they don’t want to pop it.”

The stock market is not the only reason the Fed is changing. Banks, once the principal means by which the Fed exercised its control over the economy, have grown less important as Americans have turned to the stock and bond markets for money to buy houses and build businesses. This has forced the central bank to look elsewhere for ways to make its will felt.

In addition, as economists have come to believe that people’s expectations about the economy’s direction are crucial to their decisions about consuming, working and retiring, the Fed has concluded that managing those expectations through talking is increasingly important.

Change has not come easily to the central bank. One example: The new openness policy under which it announced last week’s interest rate tilt was not, as widely reported, approved recently. It was approved more than four years ago; it took the Fed that long to bring itself to use it.

But then, that may be breakneck speed for an institution that until recently believed it should tell the public as little as possible about what it did.