Interest rate uncertainty runs hot and cold

  • James McCusker / Herald columnist
  • Saturday, March 25, 2006 9:00pm
  • Business

An old house lets you know who the boss is. It is the occupants who must adapt to its eccentricities.

No matter how lovingly maintained, for example, the plumbing system of an old, multistory house can introduce an element of uncertainty into such routine things as taking a shower. Factors such as distance from the overburdened water heater, mysteriously varying pressure and time to run out the glacier-melt in the pipes, encourage both patience and the use of unvarying ritual. The careless or forgetful run the risk of being chilled to the bone or poached – sometimes both, in that order.

As a guest in an old house, eventually we have to confront the uncertainty of the shower.

If the shower is too cool, we turn the valve, expecting more warm water. When nothing happens, we turn the valve more decisively. Again, nothing happens. Then, just as we are contemplating another valve turn, a blast of near-scalding water hits us. Unable to stand in its flow, we cringe against the wall and stretch to reach the valve. Eventually we succeed in turning it back down. Of course, nothing happens for a while, and then the glacier-melt returns. The uncertainty of the controls restarts the too-cold, too-hot, cycle, and we finally accept our fate. We resolve to call it invigorating.

Dealing with uncertainty is a prized leadership skill in many areas – military strategy, politics, sports, business and economic policy-making. Ask anyone who has made them: The tough decisions are always based on insufficient, inadequate or conflicting information.

Sometimes there is also uncertainty about response time. This is especially true of economic policy – which is why being chairman of the Federal Reserve is so much like taking a shower in an old house. The Fed controls the money supply through interest rates. But when you turn the valve to raise or lower rates, you are not sure how long it will take to have an effect. And, partly because of that delayed response, you are not sure when or how much to turn the valve.

Ben Bernanke, the new chairman of the Federal Reserve, is in precisely that situation. He has to make a decision whether to raise interest rates or wait and see if previous rate increases are taking effect – in other words, turn the valve or wait and see what happens.

He doesn’t suffer from a lack of conflicting information. There is evidence that inflation has peaked, and there is evidence that it has not. There is evidence that the economy is overheating, and there is evidence that it is not. There are reports that the job market is tightening up enough to push wages up, and there is evidence that new entrants to the labor market will keep wages stable.

What makes the Fed’s problem even more interesting is “The Mystery of the Secret Relationship” between short-term and long-term rates. By both common sense and economic theory, we would expect long-term rates to be higher than short-term rates. After all, the longer your money is tied up, the more likely it is that bad stuff will happen, so you want higher interest to offset the higher risk.

Economists and financial people call the path that interest rates take as maturity lengthens the yield curve. Normally it moves upward as the time to maturity increases, looking like the forward slash mark on a keyboard. This has not been the case recently, though, and no one really knows why. Long-term rates have been equal to or sometimes even lower than short-term rates – the so-called inverted yield curve situation.

Bernanke says that if long-term rates are low because of a global savings glut, then short-term rates should be kept lower than usual. On the other hand, if long-term rates are low because the supply of long-term bonds was insufficient to meet the demand from pension funds, then short-term rates should be kept higher than usual.

In technical terms, we’re in the shower and not sure whether to turn on more hot water, more cold water, or wait to see what happens.

In Bernanke’s view, the effectiveness of the Fed can be improved by greater transparency – announcing not just specific monetary targets but also its intentions, its thinking, and its decision-making process.

This will work great if the system can be relied on to respond predictably to our controls. Like an old house, though, our economy doesn’t give up its secrets easily. And when we have, as in the yield curve, clear evidence that we don’t fully understand all of our economy’s mysteries, transparency is not likely to be more effective than announcing in the shower that we’re turning the hot water faucet. What happens next may be surprising.

James McCusker is a Bothell economist, educator and consultant. He also writes “Business 101” monthly for the Snohomish County Business Journal.

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