The 'Conundrum' Explained
In recent months, one overriding debate has raged within the world- wide financial community. How can long-term U.S. interest rates be so low? And how can so many economists have been so wrong on their interest rate forecasts? No less a figure than Alan Greenspan, chairman of the Federal Reserve Board, famously described this question as a "conundrum" in congressional testimony earlier this year.</br></br>It is stunning for the head of our central bank to describe himself as mystified by the behavior of overall rates. But he has plenty of company. This observer cannot recall a bigger disconnect between conventional wisdom and market reality on such a central issue. Indeed, today, yields on 10-year and 30-year U.S. Treasury securities have fallen to the astonishingly low levels of 4.1% and 4.4% respectively. Both are lower than the average annual yield for these securities over the last 25 years. These low rates persist even in the face of powerful factors which, in historical terms, should drive them up, including monetary policy itself, a strong U.S. economic growth outlook and the increasingly large size of our current account deficit. This contradiction is, in essence, the conundrum.</br></br>Three alternative schools of thought have emerged to explain it. One is that the bond market has overshot. A second is that the growth outlook is actually weaker than the consensus forecast, and the bond market is discounting such slower growth before it manifests itself. But the right answer involves excess global liquidity which, for the moment, has nowhere else to go but into dollar-denominated fixed- income assets like U.S. Treasury securities.</br></br>---</br></br>Before we proceed, let's review the conundrum itself in detail. Chairman Greenspan's precise comment referred to the unprecedented behavior of longer-term interest rates in light of recent monetary policy. He noted that the Federal Reserve Board has raised the Federal Funds Rate eight times since June, 2004. Mr. Greenspan emphasized that past increases in the shortest-term rates have always pushed up long- term rates. But not this time.