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S. Balakrishnan

Should inflation pick up beyond the Fed's comfort level, a more aggressive interest rate stance is certain.

US bond markets were rocked by two events last week.

First, it was the testimony of the Chairman of the US Federal Reserve, Mr Alan Greenspan, to the Senate Banking Committee. He thought the US economy was shaping up well and the Fed's interest rate was still "low". More significant was his comment that the phenomenon of bond yields falling amidst serial Fed rate rises was a "conundrum".

The implication was clear. Mr Greenspan thought yields should be higher. All sectors of the bond market sold off with 10 years rising from about 4.1 per cent to close to 4.2 per cent.

There were spikes in the yields of shorter maturities as well. Worse was to come. Last Friday saw the release of the Produce Price Index (PPI) for January.

At the overall level, the data came in as forecast at 0.3 per cent but the more-widely watched ex-food and energy figure was 0.8 per cent. Once again bonds got punished. The yield on 10-year Treasuries shot up past 4.25 per cent. Is the conundrum at long last being unravelled?

Are we at the beginning of a secular rise in bond yields? Will the Fed continue with its "measured" pace of rate increases or opt for accelerated moves? One point is clear.

Should inflation pick up beyond the Fed's comfort level, a more aggressive interest rate stance is certain. The key to monetary policy is obviously the behaviour of prices.

Everyone knows Mr Greenspan's favourite inflation barometers - core CPI (i.e., net of food and energy) and the core Personal Consumption Expenditure index. The market also believes that as long as these remain within two per cent, the Fed is unlikely to step up the pressure on rates.

Mr Greenspan himself was quite sanguine about inflation in his testimony, remarking that it seemed well-contained and expectations too remained anchored.

The hope for bonds must be that the PPI does not foreshadow a bad CPI. In recent years, the PPI has been running ahead of the CPI, suggesting cost increases are not being passed on to consumers.

Even the dollar's steep fall against the euro and yen from $0.8 to $1.3 and 135 yen to 105 yen has not dented end-product prices in the US. Nor have increases in commodity prices.

But Mr Greenspan suggested that exporters to the US may be reaching the end of the tether and forced to raise prices, if the dollar declines further. There is every possibility of a benign CPI following the higher than expected PPI.

In which case, bond yields will fall back and we will be back to the "conundrum"!

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