By Nell Henderson
Washington Post Staff Writer
Friday, March 10, 2006
The Federal Reserve might have to raise its benchmark short-term interest rate higher than it would otherwise to keep inflation contained because low long-term rates are stimulating the economy, a top central bank official said yesterday.
Economists continue to debate why long-term interest rates have stayed relatively low in recent years, pointing to several global financial trends as possible explanations, Timothy F. Geithner, president of the Federal Reserve Bank of New York, said in a speech.
"To the extent that these forces act to put downward pressure on interest rates and upward pressure on [stock, real estate and other asset] prices, they would contribute to more expansionary financial conditions," Geithner said. In response, he said, the Fed might "have to act to offset these effects" to prevent inflation from taking off.
Geithner also appeared to challenge new Fed Chairman Ben S. Bernanke on the causes of the record U.S. trade deficit, just five weeks after Bernanke took office and less than three weeks before he chairs his first Fed policy meeting.
Geithner is vice chairman of the Fed's top policymaking committee and delivered his speech as central bank officials are weighing how much to raise their benchmark short-term interest rate. Futures markets show that investors firmly expect the Fed to raise the rate to 4.75 percent from 4.5 percent at its next meeting March 27-28 and that they believe the committee probably will lift the rate again in May to 5 percent.
Geithner "was alluding to several trends that suggest the Fed may have to hike further because these international trends have kept the cost of capital lower than it would be otherwise," said Mickey Levy, chief economist of Bank of America Corp.
The Fed began raising its benchmark rate in June 2004, when it was at a very low 1 percent. The federal funds rate -- the rate charged between banks on overnight loans -- directly influences short-term rates, such as banks' prime rate on business loans and many consumer loans linked to the prime. Those rates have risen steadily as the Fed has lifted the federal funds rate in 14 steps over 19 months.
In the past, a rising federal funds rate also caused increases in long-term interest rates, such as those on mortgages and 10-year Treasury bonds and corporate debt. But those rates are determined by global financial conditions and fell for many months after the Fed began raising its benchmark rate -- a puzzlement former Fed chairman Alan Greenspan famously called a "conundrum."
Long-term rates have been rising this year but remain historically low. The average rate on a 30-year, fixed-rate mortgage, for example, was 6.37 percent last week, Freddie Mac reported yesterday.
Geithner said U.S. long-term rates have stayed relatively low because many factors have prompted foreign investors to pour money into U.S. stocks, bonds and other assets. They include low U.S. inflation, slower growth abroad, the growing demand of pension funds for long-duration investments, and countries' different exchange rate, interest rate and budget policies.
These developments also have contributed to the swelling U.S. current account deficit, the broadest measure of the nation's trade gap. Geithner questioned Bernanke's theory that the deficit primarily reflects a worldwide "savings glut," resulting from excess saving in many foreign countries relative to investment opportunities.
Bernanke believes that much of that savings is being invested in U.S. assets, helping hold down long-term interest rates.
Geithner, however, said the theory of weak investment demand "is hard to reconcile" with relatively robust investment growth, strong global economic growth, and rising prices for stocks and other assets.
All these trends and debates make the Fed's task more difficult, he said. "They underscore the importance of being open about the greater level of uncertainty we face in understanding the forces at work" on inflation and economic growth.