The Fed's June Meeting: Swimming Against the Tide of Interest Rates?

In America did the Federal Reserve
A stately pleasure land decree,
Where Dollar, the sacred river, ran
Through markets measureless to man,
Down to a sunless sea.

In a week and a half, the Federal Reserve's Open Market Committee will hold its June meeting. As usual, the most important question will be what the Fed does and says about interest rates. Stepping away from the anxieties of the moment and looking back at the last 15 or 20 years, one can see that the Fed has tended to followed market signals. Fed interest rate cuts and increases were often anticipated by the movement of market interest rates. The market's anticipation of monetary policy made it easier for the Fed to change government controlled rates, since it was leading where the market was prepared to follow (and sometimes had already gone).

Short term interest rates haven't changed in recent months. They are effectively controlled by the Fed's target rate for federal funds, which is currently between 0% and 0.25%. The price of short term dollars is what the Federal Reserve says it is. In effect, the Fed uses monetary policy as a price control.

However, the longer maturities in the bond markets roam much more freely. They are largely creatures of the market, rambling high and low as they wish. The Federal Reserve tried to corral them late last year and earlier this year with its quantitative easing program of buying longer term debt. But the Fed needs to practice bunching up the herd and moving it in the desired direction. Long term rates sprang loose and have risen sharply. A month ago, two-year Treasury notes were yielding around 0.87 %. Today, it's more like 1.27%. Ten-year Treasuries were yielding about 3.11% a month ago. Now, it's closer to 3.79%. Thirty-year Treasuries were yielding approximately 4.1 %. Nowadays, their yield is in the range of 4.64%. Mortgage rates have followed, leaving many would be re-financers and buyers stranded. At the same time, oil and gasoline prices are rising sharply, a natural market response to the flood of dollars but a threat to economic recovery.

The Fed's low interest rate policy is meant to spur economic activity and hoist the American consumer back on a lofty pedestal. But it's pretty clear from market signals that bond investors are nervous about all the money the Fed is printing with its low interest rates (and its quantitative easing debt purchases). While lots of well-credentialed commentators pooh pooh the threat of inflation (they evidently don't buy gasoline), the people with serious money on the line (i.e., bond investors) see things differently. They are trying to signal the Fed to move interest rates up. With the current crisis mentality in our nation's financial center (Washington), that's not happening any time soon.

But then the question comes up, what will happen when the government tries to fight the market's desire for higher rates? Today's incipient combination of rising commodities prices, rising mortgage rates and lots of government cash still sloshing around in the markets could result in another cycle of asset bubbles that painfully burst while the real economy stagnates. One wouldn't characterize this scenario as stagflation, but so what? It's bad. And bad isn't good.

Usually, governments that fight markets win in the near term and lose in the long term (recall the Soviet Union, a nation that no longer exists). Governments that accommodate market forces tend to survive (as in "Communist" China). Politically speaking, the United States is hardly about to splinter; if anything, it's rallied around its new President. But the Fed is increasingly trying to swim against market currents, and that's increasingly disturbing.