Stephen King: When monetary tools start to lose their edge

I've written in the past about central bankers that have so much credibility that they never have to change interest rates. So long as we all believe that they know how to control inflation and, from time to time, will take the necessary steps to control inflation, our own inflation expectations need never change. And if inflation expectations are stable, there's no need to change monetary policy.

I've written in the past about central bankers that have so much credibility that they never have to change interest rates. So long as we all believe that they know how to control inflation and, from time to time, will take the necessary steps to control inflation, our own inflation expectations need never change. And if inflation expectations are stable, there's no need to change monetary policy.

Looking at the European Central Bank's record over the past 19 months, it increasingly seems as though Jean-Claude Trichet and his colleagues have managed to get themselves into this envious position: lots of policy meetings but absolutely no changes in official interest rates whatsoever. But what about central bankers whose monetary tools begin to lose their edge? What if changes in interest rates don't have the desired effect? What if the economy starts to respond in unusual ways?

Central bankers obviously adjust short-term interest rates, but they also have to take a view on how those changes in short-term interest rates feed through to the economy as a whole. In economic circles, the sometimes complicated linkage between short-term interest rates and the ultimate effects on output and inflation is known as the transmission mechanism. Ideally, the transmission mechanism should be stable, and if not, at least predictable. What happens, though, if the transmission mechanism starts to misbehave?

This may be a question that the Federal Reserve is having to address at the moment. No central bank would ever want to admit that the linkage between policy changes and economic activity is becoming increasingly uncertain but that, nevertheless, seems to be the Federal Reserve's challenge.

The left-hand chart rather nicely captures the problem. Over the past 12 months, the Federal Reserve has raised Fed funds - the equivalent of base rates in the UK - from a trough of 1 per cent to 2.25 per cent. Over the same period, 10-year Treasury yields have done nothing, stuck at around 4.2 per cent. Normally, rising short-term interest rates are accompanied by some increase in long-term interest rates, but on this occasion the linkage hasn't worked.

One possible explanation might be that markets believe that the rise in short-term interest rates will be quickly reversed, thereby limiting the degree to which there should be a rise in long-term interest rates. On closer examination, though, that can't be true: the right-hand chart shows that, on the basis of futures contracts, financial markets expect the Federal Reserve to continue raising the Fed funds rate all the way up to 3.75 per cent by the end of next year.

The lack of action at the long-end of the market creates some particular problems in the US. Unlike the UK, the majority of mortgages are linked to long-term interest rates rather than short-term interest rates. So, unless long-term interest rates rise as short-term interest rates go up, a lot of homeowners might simply shrug their shoulders and carry on spending, potentially making monetary policy ineffective. Whether monetary policy is being tightened to prevent inflation from rising, or whether it is being tightened to remove economic imbalances (household saving too low, balance of payments current account deficit too high), if the link between short-term interest rates and long-term interest rates begins to break down, the effects of monetary policy changes become increasingly uncertain.

So why is it that long-term interest rates haven't risen? Here are three possibilities.

First, long-term interest rates no longer reflect economic fundamentals. Those people buying long-term government paper are perhaps doing so for other reasons. Asian central banks, for example, constantly have to deal with capital inflows that threaten to push their currencies higher against the dollar. Through offsetting foreign exchange intervention, they acquire more and more US government and agency paper, thereby keeping prices higher and yields lower. As a result, US monetary conditions remain unusually relaxed despite the rise in short-term interest rates.

There are two solutions to this problem. Either Asian central banks give in to speculative pressure and allow their currencies to rise (the G7 preference) or foreign speculators are discouraged from buying Asian currencies (perhaps by the G7 accepting that there is not likely to be any revaluation of Asian currencies, in which case the need for Asian central banks to buy US fixed income assets would be significantly reduced).

Second, the Federal Reserve is now so credible that changes in short-term interest rates keep inflationary expectations very stable. Long-term interest rates tend to be higher if inflation is expected to rise, or if there is greater uncertainty about the future inflation rate. If a central bank is entirely credible, the case for long-term interest rates rising when short-term interest rates go up is a lot less.

The problem with this argument, however, is that inflationary expectations have risen a bit over the past 12 months, as reflected in index-linked bonds. Put another way, the stability of long-term interest rates has reflected an increase in inflationary expectations offset by a reduction in "real" (inflation-adjusted) yields. The market seems to be suggesting that the mix between growth and inflation has got worse: less growth than before, but more inflationary pressures.

Third, one obvious longer-term concern is the sustainability of the US current account deficit. We know that the Federal Reserve has become increasingly concerned about the deficit in recent months. But how might the deficit position be resolved? The most obvious steps would be tighter fiscal policy (likely to reduce long-term interest rates), slower domestic demand growth (also likely to reduce long-term interest rates) and a weaker dollar (likely to raise long-term interest rates but constrained because of Asian central bank purchases of US fixed income assets).

The puzzle, though, doesn't end there. Any reduction in the US current account deficit should eventually be consistent with lower long-term interest rates. But any increase in short-term interest rates that fails to lift long-term interest rates delays the reduction in the current account deficit. In other words, the expectation that, eventually, the US current account deficit might come down actually makes it more difficult for the US current account deficit to come down because, with persistently low long-term interest rates, consumers will carry on borrowing and spending.

Is there a solution? The Federal Reserve would certainly like to see tighter fiscal policy from the Bush administration, which would result in higher US national savings and hence a smaller current account deficit. It's a lot less clear, though, that the administration is prepared to deliver a fiscal tightening on this scale. Alternatively, maybe the solution will come from the financial markets themselves. What if investors began to recognise that the US economy was on an unsustainable trajectory, leading to bigger and bigger current account deficits? What then would happen? The dollar might weaken further. The bond market might initially see a bout of selling. But the real casualties would be risky US assets - equities and property, for example. And as domestic investors ran for cover, long-term interest rates would come down once again.

Knowing that long-term interest rates are low and stable is interesting, but that knowledge doesn't tell us a lot about the future path for an economy. Maybe it's a sign of heightened Federal Reserve credibility but I suspect, for many investors, yields are low because they know that the economic end-game for the US is going to be a lot more difficult than current conditions suggest.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com