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Is the Fed Losing Control of Interest Rates?

May 09, 1994|TOM PETRUNO

Investors who thought the bond market had already gone from bad to worse are searching for new superlatives, after Friday's massacre.

Some also are searching for fresh derogatory terms with which to describe the Federal Reserve Board, whose policies are once again being criticized as dangerously misguided.

On Wall Street, short- and long-term interest rates rocketed on Friday after the government reported a surprising surge in new jobs in April, more proof that the national economy is humming along.

Traders of short-term Treasury bills, convinced that economic strength will force the Fed to raise the cost of money further, pushed the yield on three-month Treasury bills from 4.13% on Thursday to 4.29% on Friday--a yield last seen in the fall of 1991.

In the long end of the bond market, meanwhile, the yield on the bellwether 30-year Treasury bond closed at 7.55% on Friday, up dramatically from 7.33% on Thursday and the highest in 17 months.

In theory, at least, long-term yields jumped not because the Fed is expected to officially boost short rates again, but because it didn't do so on Friday.

If Fed Chairman Alan Greenspan is serious about restraining the economy and thus inflation--the No. 1 worry of long-term bond investors--why wouldn't he demonstrate that by acting forcefully to tighten credit in the face of the robust April jobs report?

The easy answer to that is, the independent Fed does as it pleases. With a meeting of Fed governors already planned for May 17, Greenspan & Co. may feel there's no rush to engineer what would be the fourth official hike in short rates since Feb. 4.

But some economists believe the Fed is making the same alleged mistake in raising rates that it made while cutting rates between 1990 and 1993: It's going too slow and is in danger of losing control of the economy and interest rates.

As the economy languished in 1991 and 1992, the Fed for the most part continued a gradualist policy of small rate cuts every few months. Some economists argued throughout that period that the economy needed shock treatment--deep rate cuts, on the order of one percentage point at a time--to get moving again.

But the Fed wasn't intimidated by its critics. Though it's impossible to say for sure, the Fed's tortoise-like pace may have needlessly prolonged the economy's slump. At the very least, it helped cost George Bush the presidency.

Now the Fed is on the opposite side of the interest-rate curve, and again its critics say its gradualist policy carries too many risks. Mainly, the risk is an overheated economy.

"I think the Fed should hurry up," argues Allen Sinai, chief economist at Lehman Bros in Boston. Greenspan's policy of notching short-term rates up a quarter-point at a time, from 3% to 3.75% so far this year on the so-called federal funds rate, clearly isn't viewed as strong enough medicine by the bond market, Sinai said.

"I would (boost) one-half point on fed funds immediately," he said. Yet he warns that the Fed may already be too late to forestall more trouble in the bond market this week: Wall Street must cope with the Treasury's quarterly refinancing on Tuesday and Wednesday, which will dump $29 billion (total) in new 3- and 10-year notes on the market.

In addition, loss-ridden bond owners may decide to bail early this week rather than wait for the government's reports on wholesale and consumer inflation in April. Those reports are due Thursday and Friday, respectively, and could whip up more bond market hysteria if the numbers suggest inflation is rising even marginally over the 2.5% to 3% annualized rate now thought to be "acceptable."

Also worrisome for bond investors are recent signs of surprising strength in the economies of some major U.S. trading partners, including Germany.

"Not only might bonds be ravaged by increased inflation risks, but faster growth throughout the industrialized world will push real interest rates higher" more quickly than expected, warned John Lonski, economist at Moody's Investors Service in New York.

He predicts the 30-year Treasury bond yield will hit 7.8% by midyear, further spooking investors who desperately want to see long-term yields stabilize.

While Sinai and some of his peers worry that the Fed is moving too slowly to subdue growth and potential inflation given the economic backdrop, some Wall Streeters believe the Fed is taking the only course available.

Louis Crandall, chief economist at bond firm R.H. Wrightson & Associates in New York, argues that a dramatic boost in short-term rates by the Fed would be interpreted negatively by the bond market, not positively.

Since February, Crandall said, the bond market's paranoia has been rooted in the feeling that the Fed knows something the market doesn't: In other words, there aren't many significant signs of inflation visible today, but if the Fed is tightening credit (albeit gradually) inflation must loom.

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