The Hindu Business Line : US yield curve set to flatten

Those hoping for a clear signal on the FOMC's next interest rate move were disappointed. It was a case of running with the hares and hunting with the hounds. The customary post-meeting statement - always watched for the slightest twist and turn in language - departed significantly from that of the previous meeting. It deleted the reference to `additional firming', but did not fail to mention `inflation risk'. Prospective rate decisions are still up in the air, seemed to be the FOMC line.

Reading between the lines is the market's job and it thought the wording was an unambiguous climbdown from previous meetings. A cut in the second half of 2007 is already factored into prices. In any case, much of the Fed's tightening since mid-2004 has been neutralised by flat bond yields, which have stayed in the 4-5 per cent range, even as short rates rose from one per cent to over five per cent. This has kept the yield curve inverted for over nine months now (although the 2-year yield did slip below 10 years late last week).

Is the Fed crying `wolf' on inflation? Anti-inflation talk is the hallmark of a central bank's credibility and the Fed does not want to be short in rhetoric. Yet the latest spate of data on the US economy is bound to make the most hawkish of its members to sit up.

Housing presents an alarming picture, serious enough to find specific mention in all the FOMC statements of the last several meetings. Consumer and business confidence indices are down. Retail sales were weak and leading indicators - which presage the economy's direction down the road - are negative. Add the flutter on delinquencies in the so-called `sub-prime' loans (the retail equivalent of junk bonds) and it is clear that there is a formidable constellation of factors to cause an economic downdraft. In fact, with growth dipping below 3 per cent in the last quarter, there is little wiggle room before we stare at a recession.

Blame it on excessive tightening? Monetary policy is known for `lagged effects'. Should the Fed have halted at some point in the rate increase cycle to allow for higher rates to work their way? In hindsight, probably so. But it would have been no easy task for its (new) Chairman Mr Ben Bernanke, to ward off attacks, even from his own FOMC colleagues, that he was going soft on inflation. Buying central bank credibility has real economic costs, a point too often forgotten in debates in the higher reaches of arcane monetary theory.

Increasingly certain though rate cuts look, they are, however, unlikely to translate into a corresponding drop in bond yields. That means a flatter yield curve in the months to come.

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