WASHINGTON -- Federal Reserve Board Chairman Alan Greenspan's testimony last week to Congress sent an unmistakable message that the bond market rally is over and interest rates are headed higher.
"The signal that we are endeavoring to send is that at some point rates are going to have to move up, " Greenspan said in an uncharacteristically blunt statement to the Senate Banking Committee.
Normally, the Fed chairman declines to forecast interest rates and tip his hand on monetary policy. In this case, he wanted to make clear to Congress and the public that policymakers intend to move promptly at the next batch of troubling inflation statistics that flit across bond dealers' screens.
Currently. inflationary pressures remain subdued. But Greenspan and his colleagues at the central bank have been deeply disappointed by their inability to get inflation below 3%, and they want to be ready to prevent prices from accelerating any more.
The shift in policy marks an end to three years of gradually trimming short-term rates to offset the credit crunch and a weak economy. And it means Fed officials will probably raise the current federal funds rate of 3% to 31/4%, although Greenspan did not say when this will happen.
Essentially, the bet at the Fed is that the economy will continue to improve gradually as consumers and businesses step up demand for credit and put upward pressure on interest rates. As that happens, policymakers want to be set for a quick but gentle firming of policy so they avoid their past mistake of waiting too long to check rising price pressures.
The gradual evolution in thinking at the central bank has met with some internal disagreement. According to one banking source, board governors Wayne Angell and Edward Kelley have been arguing for a move now on rates.
Angell is a well-known hawk who has been upset at the rise in gold prices. Kelley's tough stance is more interesting because, unlike most other board members, he is not an economist, and his views are often taken at the central bank as reflecting mainstream thinking. At the same time, some of the Federal Reserve District Bank presidents have been more inclined to be neutral on rates out of lingering concerns about the soft economy. this banking source says. One notable example is Philadelphia Bank president Edward Boehne, who dissented from the Fed's decision in May to tilt toward higher rates when necessary.
Any rise in interest rates is likely to be gradual because the economy will not gain much steam in the months ahead. Greenspan conceded that small businesses continue to lack credit from their usual commercial bank sources, and defense cutbacks along with other problems will continue to act as a drag on growth.
"Greenspan and the Fed do have time," says Charles Lieberman, managing director of Chemical Securities Inc. "There is no inflationary problem today. And there is not likely to be a significant inflationary problem any time in the near future, meaning in the next six or 12 months. So Greenspan has the luxury of being able to move slowly on monetary policy."
Lieberman says he is looking for the Fed to bump up the federal funds rate to 4% by the middle of next year. But he doesn't expect any action before Labor Day, because price reports coming out of the government are expected to be positive. By yearend, he is calling for yields on the Treasury long bond to be around 7%.
Such rate increases are not expected to have much of an impact on the economy. Still, the message for home owners and businesses is to go to the credit markets now because rates will not get any lower.
In fact, rates edged up slightly last week in reaction to Greenspan's testimony. "Anybody who listened to what Greenspan said would be well served to lock in rates now," says Lieberman.
One bright spot is the deficit reduction package moving through Congress. The bond market's belief that it will go through has contributed to the drop in the long-term rates, along with recent reports from the government showing price pressures were almost nonexistent in May and June.
Greenspan said that low rates will help offset the drag caused by the load of taxes and spending reductions in the budget package. But he also warned Congress that failure to follow through would spook the bond market and send rates higher.