Global tides take some control from Fed

By Edmund L. Andrews. Copyright by The New York Times

MONDAY, MAY 8, 2006

WASHINGTON If the Federal Reserve stops raising interest rates later this year, will the rest of the world go along?
When Fed policy makers meet Wednesday to set overnight interest rates, they will almost certainly raise them another quarter-point to 5 percent. And investors will hunt for any clue about a "pause" in further rate increases.

But a growing number of economists are looking at a different possibility: that changes in the global economy could keep pushing up long- term interest rates long after the Fed stops raising its own rate.

The result would be a mirror image of the "conundrum" that perplexed Alan Greenspan, the former Fed chairman, last year. The conundrum was that long-term interest rates remained low and overall credit conditions remained easy even as the Fed raised short-term rates.

Now, even as Fed officials say they are near the end of their increases, the long-term interest rates that determine home mortgage rates and companies' borrowing costs have crept higher.

Increased anxiety about future inflation has been partly to blame, analysts say. But long-term rates have edged up around the world, suggesting that global forces are at work.

Japan, the second-largest economy in the world after the United States, is growing faster than it has in more than a decade, and the Bank of Japan has said it will begin to guide interest rates again after keeping them at zero. European growth, though still rising more slowly than in the United States, is accelerating, and the central bank is expected to raise rates soon.
Meanwhile, the economy in China surged by 10 percent last year, and Chinese leaders are vowing to spur the kind of domestic demand that would keep more money at home.

Higher growth leads to more competition for investment capital, which tends to drive up interest rates. And as interest rates rise in foreign countries, there is less incentive to seek out higher returns in the United States.

That could pose a challenge for Ben Bernanke, who took over as Fed chairman in February. Bernanke has long argued that the "conundrum" of low interest rates, and the United States' burgeoning trade deficit, stemmed in part from a "global savings glut" - a vast pool of idle money in Asia and other parts of the world that was sloshing back into the United States.

"It looks increasingly obvious that there is a boom on the globe today; it's just not happening here," said Robert Barbera, chief economist at Hoenig. "That in turn would suggest that the moderating activity here in the United States may not elicit lower interest rates. What was a conundrum for Greenspan then becomes a problem for Bernanke."

Robert DiClementi, a senior economist at Citigroup, said that speculation about the changing global demand for money has helped feed a run-up in long-term rates.

"I think people are speculating about this, speculating that growth rates may converge, that savings will come more into balance and that there is going to be a draw on capital that's going to suck money out of the United States," Di Clemente said.

Part of the recent rise in long-term interest rates reflects worries about inflation.

One crucial proxy for inflation worries is the gap between yields on conventional Treasury bonds and the yields on inflation-adjusted Treasury securities, or TIPS. That gap widened to 2.8 percent from 2.7 percent of the last month, and much of the widening occurred after Bernanke told lawmakers that the Fed might temporarily stop its rate increases.

The recent economic indicators about inflation have been mixed. Consumer prices have climbed sharply, largely because of oil prices. The Fed's preferred gauge of core inflation, which excludes food and energy prices, is up about 2 percent over the past 12 months.

That is about the upper limit of what Bernanke has described as his comfort zone for inflation. Meanwhile, economic growth in the United States was much faster in the first quarter than most economists had expected. And while job creation slowed to just 138,000 jobs in April, unemployment was only 4.7 percent and hourly wages climbed 3.8 percent over the past year - the biggest jump in five years.

But many analysts say that the inflation outlook remains fairly tame. Nonfarm business productivity, the amount of output per hour of work, rose at annual rate of 3.2 percent in the first three months of 2006.

Higher energy prices have had little impact on other consumer prices, and corporate profits are so high that many companies can absorb higher wages without raising prices.

Fed officials, who have said they are near the end of their rate-raising efforts, have predicated that on the expectation that the country's growth will slow from the torrid annual pace of 4.8 percent in the first quarter of this year to about 3 percent in the second half of 2006.

But even if the Fed is sanguine about inflation, global forces could still push up borrowing costs.

An increase in global interest rates would not necessarily be bad news for Bernanke. Higher long-term rates would help cool down American economic growth, and the housing market in particular, without requiring the Fed to take more action on its own.

But higher global interest rates could also slow the U.S. economy enough to increase unemployment.

Either way, analysts said, the economy is more dependent on global forces than was true a decade ago.
"It is more exposed because of the fact that it needs massive amounts of cash from the rest of the world," said Nigel Gault, senior economist at Global Insight, a forecasting company based in Lexington, Massachusetts. "In a strange way, the world is riskier for the United States if everyone else is doing better."