WASHINGTON -- Maybe the bond market hasn't lost a wheel after all.
Bonds have rallied in a delayed reaction to the Federal Reserve's third increase in short-term interest rates that lifted the federal funds rate to 3.75%. The yield on the Treasury's 30-year bond slipped back below 7.25% - which is where it was before the Fed tightened - to 7.15% on Tuesday morning.
At least temporarily, some of the near-hysteria about a galloping economy pushing up inflation subsided. One catalyst was the government's report of a surprisingly large $9.7 billion trade gap in February that led many economists to mark down their forecasts for U.S. growth in the first quarter.
Bond market participants seem to be getting used to the sting from the lashes being applied to the economy by Fed Chairman Alan Greenspan and his colleagues.
Reading the Clues
And there is a hope that, while the Fed may not be acting as aggressively as the bond vigilantes would like, the central bank is not too far from where it wants to be in monetary policy.
No one knows how high the Fed will have to lift short-term rates. But clues can be derived from the language used by Mr. Greenspan when he told Congress early this year that wanted to achieve a "neutral" monetary policy.
At the time, the federal funds rate was 3%, and Mr. Greenspan made clear he considered that rate the mark of an easy central bank policy.
Practically speaking, the Fed no longer wants to be a contributing factor in the economy's expansion by fostering demand for credit by businesses and consumers at artificially low rates.
Easing Up
A common analogy is that policymakers are now taking their foot off the accelerator, seeking to slow the car to within the 55 mile-per-hour speed limit.
Technically, the debate for economists lies in trying to calculate what a neutral federal funds rate would be. Most estimates fall within a range of 4% to 5%, based on the Fed's notion that 3% is too low because it is zero when adjusted for inflation. The question is how much of a premium to add, and for that there is no exact answer.
But there are some reasonable formulas. Stuart Hoffman, chief economist for PNC Bank Corp., in Pittsburgh, has found that in the period from 1960 to 1979, the federal funds rate averaged 1.25% over the rate of inflation. The spread since January 1990 is not much higher at 1.32%.
Goal Seems in Sight
In the 1980s, the spread was a much higher 4%, but that was a period when Paul Volcker had to squeeze bank reserves without mercy to kill double-digit inflation.
Figuring a 3% rate of inflation for prices of goods and services excluding food and energy - the so-called core rate of inflation that Fed officials like to use - a federal funds rate in the range of 4% to 4.5% might be neutral.
With another widely anticipated rate hike in May from the current 3.75% to 4%, a case can be made that the Fed is not far from accomplishing its goal.
The key to this scenario is the economy's momentum, which has been too rapid for the taste of Fed officials. Once signs accumulate that growth is moving toward a noninflationary pace in the range of 2.5% to 3%, they can stop raising short-term rates. Until that happens, they will keep raising rates.
Forecast for Tightening
Some analysts believe the economy has so much punch that the Fed will keep tightening this year and into 1995. At the Mortgage Bankers Association, the latest forecast calls for fixed mortgage rates to hit 9% next year.
However, within the Clinton administration, the President's economic advisers believe the recent rise in long-term rates is the result of unwarranted market fears about a runaway economy.
At the same time, they expect higher rates to act as a slight brake and keep this year's growth to 3%.
