The dollar: Interest and exchange rates

WORLD MONEY/ Has a steeper yield curve correctly factored the expected rise in interest rates?

Alan Greenspan was nominated last month for his 4th term as chairman of the US Federal Reserve. He is already 78 and should he manage to complete the next term, he would have occupied the seat for 24 long years.

Over the period, he has seen it all "" inflation and recession, unprecedented economic growth, stock market crashes (October 1987 and early 2000), fiscal deficits and surpluses, and four presidents, including a father-and-son pair.

He has also converted policy statements into something of an art form, leaving markets guessing at his intentions and timing. Indeed, something of a mini industry has sprung up specialising in the analysis of every nuance of his statements "" the analysts' fans require the explanations offered to be plausible, not necessarily "right".

Those brave enough to be desirous of interpreting Greenspan-speak are welcome to hone their skills by looking at the last couple of changes in the statements issued after the Federal Open Markets Committee (FOMC) meetings that set the all-important overnight Fed Funds rate in New York.

In five successive statements, the Fed had said that policy accommodation, in other words, low interest rates, could be maintained "for a considerable period". Towards the end of January, the wording was changed to say that the Fed would "be patient" in changing policy.

Last month, there was another change, namely, that "policy accommodation can be removed at a pace that is likely to be measured". What exactly do the changes from "considerable period" to "patient" to "measured" signify?

To be sure, highly-paid analysts of the interest rate markets are not interested so much in trying to understand the Fed's intentions as how market participants are likely to interpret the statements.

The game has not changed much from Keynes's times "" "It is not the case of choosing those which, to the best of one's judgement are really the prettiest, nor even those which average opinion genuinely thinks is the prettiest...we devote our intelligences to anticipating what average opinion expects the average opinion to be."

But such speculation about market psychology apart, what has happened on the ground? For one thing, there is no longer any talk of the possibility of deflation. Core inflation, which had continued to fall until early this year to barely 1 per cent, has now started going up. It is currently around 1.5 per cent.

The headline rate of inflation, that is inclusive of the volatile energy and food prices, is still only 2.3 per cent, despite the fact that all commodity prices from crude oil to steel to gold have been going north for quite some time, at least in dollar terms.

Even the fall of the dollar against the euro and yen over the past couple of years does not seem to have affected retail prices much. No wonder the Federal Funds rate has been kept unchanged at 1 per cent since mid-2003, its record low for almost half a century.

To be sure, market rates have gone up in the past three months or so in response to strong job numbers. The five-year swap rate that was at its lowest at 3 per cent in mid-March, is now at 4.4 per cent.

Over the period, the six-month Libor has also gone up, if more modestly, from 1.15 per cent to 1.8 per cent. The result, of course, is a steeper yield curve than the one existing three months ago. Has the steepness correctly factored the expected rise in interest rates?

Those in the "carry trade" "" that is, borrow overnight and invest in bonds "" would be happy to pay almost anything for a correct answer.

Alas, only time and perhaps Greenspan knows it. The only point one can be reasonably sure is that 1994, with its six increases in the Fed Funds rate, is unlikely to be repeated. Meanwhile, prices of emerging market and junk-rated bonds have fallen much more than treasuries, widening the credit spreads.

What is truly amazing is that a benign and accommodative monetary policy has continued so long in the background of a breathtakingly irresponsible fiscal policy. The fiscal balance has had a sharp U-turn amounting to a 6 per cent plus (of GDP) turnaround from surpluses to deficits in the course of less than four years.

On top of the huge tax cuts, increases in security and defence expenditures and the war in Iraq continue to take a huge toll. The government continues to fudge figures, making every effort to avoid bringing into sharp focus the size of the hole it has dug for itself.

Even The Economist, which has been the most loyal and brave supporter of President Bush's efforts to "liberate" the ungrateful Iraqis, recently characterised the Budget numbers as a "farce" and "irresponsible".

The one place where the fiscal imbalances are showing up is in the external sector. The current account deficit in the current year is likely to cross 5 per cent of GDP, and the US's external liabilities will mount to 35 per cent of GDP by the end of the year.

While the dollar has fallen in the international market, particularly against the euro, its fall is nowhere near what is needed to correct the imbalance. True, exports have grown "" but imports have grown even faster to satisfy America's huge appetite for consumer goods.

Capital flows remain strong, not so much from private investors, as from Asian central banks. It is almost as if they have made an unwritten pact with the US "" you buy our goods and services, we buy your paper.

In the process, the Asians are supporting the dollar's exchange rate and financing the US fiscal deficit even while helping keep interest rates low. How long will this continue? Even Greenspan may not know the answer.

Email: avrco@vsnl.com