Yesterday Greenspan raised short-term interest rates by 0.25%. He essentially gave a two-part justification for this move. First, the Fed announcement said that the economy is still doing pretty well: “Output growth appears to have regained some traction, and labor market conditions have improved modestly.” Second, the announcement argued that even with this increase in short-term rates, monetary policy is still expansionary. As the announcement put it, “the Committee believes that, even after this action, the stance of monetary policy remains accommodative.”
But I disagree with both points. First of all, the economy has decidedly slowed from its moderately rapid growth of six months ago, as I argued here. The economy appears to still have lots of excess, unused capacity, inflation is falling, and employment growth has fallen.
Furthermore, notice what’s happened to bond yields: they’ve also fallen significantly over the past couple of months. The yield on the 10-year bond has fallen from about 4.6-4.7% over the summer to just 4.05% today. This is not the sort of thing one expects to see during a recovery. In fact, long-term interest rates are pretty good predictors of the health of the economy over coming 6 or 12 months. The following chart illustrates.
When the economy is expected to do well enough to create jobs, the bond market generally bids up interest rates, both because of expectations of higher demand for loanable funds, and because of possible inflation expectations. But now long-term interest rates are approaching the low levels of the summer of 2003, when the economy was in the midst of the job-creation doldrums. To me this suggests that the bond market has no faith in any significant job creation over the next several months.
What about the Fed’s second point, that its current policy stance is still expansionary? One good way to guage this is by looking at the yield curve. In general, the steeper the yield curve — meaning a large difference between short-term interest rates and long-term interest rates — the more expansionary monetary policy is. But as of today, the 10-yr bond yields just 2.3% more than the Federal funds rate. A year ago, when monetary policy was truly expansionary, that gap was nearly 3.5%. The last time the yield curve consistently had so little slope was back before September 2001, when the Fed was just in the early stages of loosening monetary policy.
Furthermore, real (inflation-adjusted) short-term interest rates have risen dramatically over the past few months, as the following chart illustrates.
The chart shows the 3-month T-bill rate minus the 3-month inflation rate in the core CPI. Aside from an unexpected dip early this year (most likely due to the spike in oil prices which caused an unusual amount of inflation), real interest rates have hovered around zero ever since the Fed loosened policy in 2001. My reading of this chart is that the Fed’s recent moves mark a definite departure from this lengthy period of an expansionary monetary policy, not a continuation of it. Greenspan may assert that recent interest rate moves still leaves policy relatively loose, but I think it’s equally possible to argue that policy is now becoming relatively tight, at least when compared to the past 3 years.
Mind you, I’m not necessarily arguing that raising interest rates by .25% right now will have a big negative impact the economy. But on the other hand, I’m quite sure raising rates right now won’t do anything to help the economy as it appears stuck in a fairly drawn-out pause in its recovery.