Too Risky for Fed to Let Rates Stand?

Entire forests will be sacrificed in coming months for the paper needed to hold all the speculation about the future of U.S. interest rates.

As with many things that are unknowable, the temptation is to label all conjecture about Federal Reserve policy moves as so much blather -- the equivalent of obsessing over who Donald Trump would pick to be his apprentice.

But Trump’s minion isn’t likely to affect your life in any way. Unfortunately, the same can’t be said about what the Fed finally will do with interest rates. The actions (or inactions) of the central bank will have consequences for every consumer, investor and business.

Last week, the pressure on the Fed to boost rates was ratcheted up after the government said consumer prices rose at an annualized rate of 5.1% in the first quarter. The data strongly suggested that the growing U.S. economy finally was giving more companies the ability to raise prices of goods and services.

Many economists said the Fed could no longer justify holding its key short-term rate at a 46-year low of 1%, where it has been since June. The central bank, critics said, is risking all of the bad things that come with too-cheap money -- inflation, excessive market speculation and misallocation of resources.

Yet at least two prominent Fed officials quickly went on the defensive. Fed Gov. Ben Bernanke said in a speech in Chicago that it was “early” to be assuming that the recent uptick in inflation was sustainable. In a separate address in Maryland, Richmond Fed President Alfred Broaddus said policymakers still were “some distance” from reacting to signs of a stronger economy.

Who knows what “early” and “some distance” really mean? The Fed might well prefer to keep rates where they are. But there are three risks to putting too much credence in that scenario:

* Risk No. 1: Fed officials can talk all they want about the need to be patient. But they won’t be able to ignore an uptrend in raw inflation data if that is what’s in store.

The central bank, understandably, is sensitive to the risk of slowing the economy with higher interest rates before businesses begin to ramp up hiring. Nonetheless, the Fed knows it has a primary duty to the nation to keep inflation under control.

Another couple of months of stronger-than-expected inflation data and the Fed’s hand could be forced to move the interest rate lever, whether hiring is robust or not.

* Risk No. 2: Fed policy is, to a large degree, at the mercy of bond investors.

If they demand much higher yields to buy long-term bonds -- because they’re afraid of inflation, which erodes fixed-income returns over time -- the pressure would mount on the Fed to raise short-term rates.

The federal funds rate, the overnight loan rate among banks, is directly under the Fed’s control. (That’s the rate that now is at 1%.) But the central bank doesn’t directly control longer-term rates. Investors set those in buying and selling bonds in the marketplace.

The yield on the 10-year Treasury note, a benchmark for long-term rates, was at 4.34% on Friday, up from 3.68% in mid-March and near a four-month high. Clearly, bond investors are more nervous about inflation. But they don’t appear to be panicking. The 10-year T-note was as high as 4.6% in September, so yields still are below last year’s highs.

If investors start to panic, however -- and bond yields rise substantially -- it would be a powerful signal to the Fed to begin tightening credit. So watching the bond market now is at least as important as listening to the Fed.

* Risk No. 3: The Fed doesn’t know whether its “ideal” inflation rate would be OK with bond investors or average consumers.

Policymakers began to warn a year ago that inflation had fallen too low for comfort. The core U.S. consumer price index, which excludes food and energy costs, rose 1.1% in 2003, the smallest increase in four decades.

The Fed feared that the economy could soon tip into deflation, meaning a broad-based decline in prices similar to what happened in Japan in the 1990s. That’s why it has maintained that easy credit was a necessity for the economy, to boost demand for goods and services.

Now, many economists believe the Fed would be happy with an annual inflation rate of about 2%. The economy, too, might be just fine with that, since a little inflation can be good.

But as inflation rises, the problem for financial markets could become that investors would begin to wonder where it would stop.

In other words, the Fed might be confident that, even if it kept interest rates low, inflation wouldn’t get much beyond 2% on a yearly basis. If Wall Street fears a higher number, however, investors’ perceptions could matter more than the Fed’s reality.

In January 1994, Fed Chairman Alan Greenspan spoke to Congress about that risk. In a recent report, Edward Yardeni, economist at Prudential Equity Group in New York, recounted Greenspan’s testimony:

“He noted that labor market conditions remained weak, with employers relying to an unusual degree on overtime and temporary employees, and that overall inflation remained subdued despite upward pressure on some industrial commodity prices,” Yardeni wrote. “Nonetheless, he hinted at a new concept, namely that the Fed’s job was to anticipate a rise in inflationary expectations and to stop it from happening by raising interest rates.”

What’s interesting is that Greenspan’s description of the economy back then sounds a lot like the economy now.

Even more interesting is that, five days after that testimony, the Fed began to raise interest rates after holding them down for two years.

History won’t necessarily repeat. Still, investors and consumers who have been assuming that tighter credit was a long way off ought to consider what might happen if they’re wrong.

*

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