In a wide-ranging analysis of bond market fundamentals, St. Louis Fed President William Poole said the focus should be on long-term interest rate basics. “Longer-run fundamentals tend to get lost in a welter of short-run considerations that fade into oblivion quickly as a new set of short-run concerns dominate the news,” he said. Poole spoke to a group of financial analysts at Washington University’s Olin School of Buisness on “Prospects and Risks in the Bond Market,” Sept. 4.
Poole told the analysts he wanted to convince them that “In practice the Fed has no latitude as to how to set the intended federal funds rate, except for matters of short-term timing, if it wants to achieve its goals” of price stability and economic growth. “Low and stable inflation and output growth along its long-run growth path imply a certain, though not constant, long-term interest rate,” he said. “If the Fed does not deliver a path for the intended federal funds rate consistent with the desired economic outcomes, then those desired inflation and output goals will not be realized,” he said.
Poole noted that the benchmark 10-year Treasury rate has three components:
- the real rate of interest,
- expected inflation and
- a risk premium for unexpected inflation.
The real rate, he said, depends mainly on the expected productivity of physical capital. Poole said these interest rate components are forward looking and depend on investor expectations. “We can’t directly observe these components, but we can estimate them,” he said, noting that estimations come mainly from surveys and from the yield difference between regular Treasury bonds and Treasury inflation-indexed securities.
Poole reviewed historical changes in long-term bond rates, which peaked at 13.91 percent in 1981 and fell through the 1990s to about 6 and 3⁄4 percent in late 1999. Shifting to the 10-year indexed bond, Poole said its yield, which had been about 4.4 percent in late 1999, was down to about 1.5 percent in mid-2003. “I think the right interpretation of the rebound in the real rate of interest recently is that the market expects a resumption of economic growth, with stronger credit demands.”
Poole said the market appears to have “great confidence” in the Fed’s commitment to price stability and its powers to maintain a low and stable inflation rate. “Moreover, the stunning second quarter productivity increase announced this morning and the strong case that handsome productivity increases will continue make inflation control considerably easier than otherwise.”
Poole said that regarding prospects and risks in the real interest rate, that “risks are tied to risks with respect to economic growth. As I examine growth expectations of professional forecasters, my read is that the consensus outlook is for solid and balanced economic growth. However, as I always emphasize, forecasts change over time, sometimes significantly and at any given time there is a range of professional opinion on the outlook.”
If the recovery continues to be sluggish, Poole said, bond rates will likely fall. “Should we see a gangbusters recovery, the prospects are that rising credit markets will drive bond rates above current levels. In either case, the action will be primarily in the real rate of interest and not, I believe, in the inflation component of rates.”