Three Discussions of the Low Long Rate Conundrum

BusinessWeek’s Kathleen Madigan, Fed Governor Susan Bies, and Bloomberg’s Caroline Baum discuss the low long-term interest rate conundrum. Here are summaries of their remarks beginning with BusinessWeek’s Kathleen Madigan:

The Long Wait for a Housing Slump, By Kathleen Madigan, BusinessWeek Online: Alan Greenspan's "conundrum" has been the housing sector's savior. … With no cooling in sight … why hasn't the big chill happened yet? It all comes down to mortgage rates, which have not risen as expected. … The drop in bond yields is unusual given the economic circumstances. Even Fed Chairman Greenspan has admitted the bond market's behavior is a riddle. … Policymakers have already noticed that ... higher energy costs ... has pushed up core inflation ... Normally, the Fed's tightening and inflation fears would be pushing up bond yields. Instead, traders seem to hold ... that ... the economy might be done growing, and so the Fed likely is just about finished raising rates this go-round. Moreover... the drop in bond yields may not be saying anything much about the U.S. economic outlook. A glut of global savings is chasing yields, and right now even a paltry 4% payout on U.S. Treasuries beats the 3.5% or less to be gotten from euro bonds. In addition, the central banks of China and other Asian nations are buying dollar-denominated assets to prevent their currencies from appreciating … Despite low bond yields, Fannie Mae's chief economist, David Berson, offers some reasons a slowdown in housing is still a good bet. First, rising prices make affordability an issue for many buyers. Second, the rates of 2003 and 2004 -- the lowest in a generation -- induced some households to buy. That pulled forward sales which otherwise would have taken place in 2005. … regulators are trying to crack down on too-easy standards for home-equity loans. At the end of the day ... a housing slowdown will depend on an attitude change in the bond market. And while market sentiment can turn on a dime, there are no signs right now that traders will pushing rates up soon.

Here are Fed Governor Bies' remarks on the conundrum along with a summary of other remarks by Federal Reserve officials from a Reuter’s report:

Fed officials leave hikes in little doubt, By Ros Krasny, Reuters: Federal Reserve officials left little doubt on Thursday that the bank has more rate increases in mind .. the Fed's program of "measured" increases in short-term rates, Chicago Fed President Michael Moskow said the bank's policy remains accommodative. Separately, Atlanta Fed President Jack Guynn said the Fed has "not yet reached a neutral policy stance." Fed Gov. Edward Gramlich, speaking in Paris, said the measured rate increases could continue. … Moskow stayed close to the Fed's central message. "We can continue to remove monetary policy accommodation at a measured pace," he said. … Federal Reserve Governor Susan Bies took on the "conundrum" of low long-term U.S. interest rates in comments to reporters after speaking at a Women in Housing and Finance event in Washington …."I honestly don't know what it's going to take. It just appears that long-term rates cannot stay at this low level," Bies said. The long rates puzzle dovetails into another worry for policy-makers, a hot housing market that has recently attracted the kind of speculative cash associated with stock market bubbles of yore. Officials repeated concerns about real estate speculation but once again stopped short of tagging the current situation a "bubble." … "At some point we do believe that the 10-year Treasury (note yield) will rise above 4 percent and take mortgage rates with it," Bies said.

Finally, Bloomberg’s Caroline Baum weighs in:

Yield Curve, More Than Shapely Body, Has a Brain, Caroline Baum, Bloomberg: … The yield curve, or the pictorial representation of the yields on Treasury securities across the maturity spectrum, has … narrowed, to the point that it's creating a source of consternation … With every indication that the Fed plans to proceed with its agenda of rate increases and every sign that long rates aren't going to budge in response (at least not higher), it's possible the curve could invert before too long. An inverted yield curve, with short rates higher than long rates, is typically a harbinger of recession. ... Not this time. … Fed officials aren't contemplating implementing a contractionary monetary policy. So what are we to make of the dramatic flattening of the yield curve? … The yield curve is a simple construct that's widely misunderstood. … I've craft[ed] a primer on the yield curve. For the purposes of this discussion, the yield curve will connote the spread between the overnight federal funds rate and 10-year Treasury note yield. 1. What's so special about two yields among thousands? … What's special is the information provided by the interaction between the two rates: one set by the central bank, the other by the market. While long rates are influenced by short rates … they're also affected by real activity and inflation expectations, not to mention a myriad of political and psychological considerations. The long rate is a window into the stance of policy. 2. My windows need washing. What do you mean by the interaction between them? … Most [central banks] use an overnight or other short-term rate as a policy tool. The monetary authority provides whatever reserves the banking system demands to achieve its target rate. If the central bank is holding the short rate steady, and market rates are rising, it's a pretty good indication that the overnight rate is too low. … Because … the demand for credit is rising faster than the Fed can supply it. 3. Who figured this stuff out? The theory behind the yield curve's role in anticipating economic growth and inflation can be traced back to the late Swedish economist Knut Wicksell (1851-1926). Wicksell argued that when the rate at which banks lend is below … the natural rate of interest, prices would rise. When the bank rate exceeds the natural rate, prices would fall. 4. How do I know what the natural rate of interest is? You don't. It's unobservable. Which is why the interaction between the two rates provides … information ... Think of the long rate as a check on the central bank. If policy is too easy or too tight, it will send up a flare. 5. Now I'm really confused. How can falling long rates be a negative? Isn't there more incentive to borrow at 5 percent than 6 percent? Yes. And that's one part of the story. If you only looked at the level of long-term rates, the Great Depression should have been the Great Boom, and Japan's lost decade should have been Paradise Regained. In both cases, low long-term rates were a symptom of weak economic growth, not a cause of stronger growth in the future. … 6. Low mortgage rates have created a boom in housing. How can you say a flatter yield curve is less stimulative? … … Ceteris paribus, declining mortgage rates make home ownership more affordable. In the micro world of housing, credit demand is strong. ... Whether it's Asian central banks or private investors wanting a risk-free investment, more people are choosing to save in dollars, which is pushing down long-term rates….

[Update: One more story on the conundrum from CNN]