I'VE WRITTEN in the past about central bankers that have so much credibility that they never have to change interest rates. So long as we all believe that they know how to control inflation and, from time to time, will take the necessary steps to control inflation, our own inflation expectations need never change. And if inflation expectations are stable, there's no need to change monetary policy.
Looking at the European Central Bank's record over the past 19 months, it increasingly seems as though Jean-Claude Trichet and his colleagues have managed to get themselves into this envious position: lots of policy meetings but absolutely no changes in official interest rates whatsoever. But what about central bankers whose monetary tools begin to lose their edge? What if changes in interest rates don't have the desired effect? What if the economy starts to respond in unusual ways?
Central bankers obviously adjust short-term interest rates, but they also have to take a view on how those changes in short-term interest rates feed through to the economy as a whole. In economic circles, the sometimes complicated linkage between short-term interest rates and the ultimate effects on output and inflation is known as the transmission mechanism. Ideally, the transmission mechanism should be stable, and if not, at least predictable. What happens, though, if the transmission mechanism starts to misbehave?
This may be a question that the Federal Reserve is having to address at the moment. No central bank would ever want to admit that the linkage between policy changes and economic activity is becoming increasingly uncertain but that, nevertheless, seems to be the Federal Reserve's challenge.
The left-hand chart rather nicely captures the problem. Over the past 12 months, the Federal Reserve has raised Fed funds - the equivalent of base rates in the UK - from a trough of 1 per cent to 2.25 per cent. Over the same period, 10-year Treasury yields have done nothing, stuck at around 4.2 per cent. Normally, rising short- term interest rates are accompanied by some increase in long-term interest rates, but on this occasion the linkage hasn't worked.
One possible explanation might be that markets believe that the rise in short-term interest rates will be quickly reversed, thereby limiting the degree to which there should be a rise in long-term interest rates. On closer examination, though, that can't be true: the right-hand chart shows that, on the basis of futures contracts, financial markets expect the Federal Reserve to continue raising the Fed funds rate all the way up to 3.75 per cent by the end of next year.
The lack of action at the long-end of the market creates some particular problems in the US. Unlike the UK, the majority of mortgages are linked to long-term interest rates rather than short- term interest rates. So, unless long-term interest rates rise as short-term interest rates go up, a lot of homeowners might simply shrug their shoulders and carry on spending, potentially making monetary policy ineffective. Whether monetary policy is being tightened to prevent inflation from rising, or whether it is being tightened to remove economic imbalances (household saving too low, balance of payments current account deficit too high), if the link between short-term interest rates and long-term interest rates begins to break down, the effects of monetary policy changes become increasingly uncertain.
So why is it that long-term interest rates haven't risen? Here are three possibilities.
First, long-term interest rates no longer reflect economic fundamentals. Those people buying long-term government paper are perhaps doing so for other reasons. Asian central banks, for example, constantly have to deal with capital inflows that threaten to push their currencies higher against the dollar. Through offsetting foreign exchange intervention, they acquire more and more US government and agency paper, thereby keeping prices higher and yields lower. …