HEAD BLOODSUCKER SPEAKS

Bernanke: Fed must watch its step
Fed chief says flat yield curve not a sign of economic slowdown, says it isn't clear why long-term bond yields are so low.

March 20, 2006: 9:41 PM EST

NEW YORK, March 20 (Reuters) - Federal Reserve Chairman Ben Bernanke said on Monday it was hard to gauge why long-term interest rates were so low and said the U.S. central bank could not rely on them as its sole guide for policy-making.
"The implications for monetary policy of the recent behavior of long-term yields are not at all clear-cut," Bernanke told the Economic Club of New York.
In his first public foray onto Wall Street since taking over as Fed chairman on Feb. 1, Bernanke ran through several competing explanations for the unusually low level of U.S. bond yields despite a steady ratcheting up of short-term interest rates by the U.S. central bank.
Bernanke revisited a thesis he first laid out a year ago that a "global saving glut" - an excess of savings because of a dearth of enticing investments - could be depressing rates.
If this were the case, he said, then as long as the factors behind it persisted "global equilibrium interest rates - and, consequently, the neutral policy rate - would be lower than they otherwise would be" to keep the economy on an even keel.
But Bernanke laid out a number of other possibilities and concluded: "The bottom line for policy appears ambiguous."
Fed policy-makers have raised benchmark overnight rates to 4.5 percent in a string of 14 steps dating to June 2004 and are widely expected to bump them up another quarter-percentage point at a meeting next Monday and Tuesday.
While overnight rates have risen 3.5 percentage points since mid-2004, the market-set rate on 10-year U.S. government bonds has barely budged.
Bernanke said that if the low level of long-term rates reflected a decline in the compensation investors demanded to cover the risk of losses on long-term holdings, then it could signal stimulative financial conditions that would require higher short-term rates than otherwise to offset.
"But to the extent that long-term rates have been influenced by macroeconomic conditions, including such factors as trends in global saving and investment, the required policy rate will be lower," Bernanke said.
Little slowdown ahead
As he had in congressional testimony last month, Bernanke said he dd not consider the current flat yield curve - with yields on short-term debt close to yields on long-term bonds - as presaging "a significant economic slowdown" as has sometimes been the case in the past.
Indeed, he said other indicators showed markets with few worries on the future. "The fact that actual and implied volatilities of most financial prices remain subdued suggests that market participants do not harbor significant reservations about the economic outlook," he said.
He said, instead, long-term rates could suggest the level of short-term rates consistent with holding the economy at full employment had declined, perhaps reflecting a lasting drag on the economy from high energy costs, slower growth in house prices and the possibility consumers will begin to save more.
But he also noted long-term rates were low around the globe and said "an explanation less centered on the United States might be required."
One other factor that Bernanke raised, but downplayed, was that large official holdings of U.S. Treasury debt accumulated by countries intervening in currency markets was doing much to push U.S. long-term rates down.
"A reasonable conclusion is that the accumulation of dollar reserves abroad has influenced U.S. yields, but reserve accumulation abroad is not the only, or even the dominant, explanation for their recent behavior," he said.
In the end, Bernanke said the Fed would need to monitor bond yields carefully, but also had to take into account a wide array of other signals on the economy's health.
"Policy-makers are well advised to follow two principles familiar to navigators throughout the ages: First, determine your position frequently. Second, use as many guides or landmarks as possible," he said.
"By not tying policy to a small set of forecast indicators, we may sacrifice some degree of simplicity, but we are less likely to be misled when a favored variable behaves in an unusual manner," Bernanke added.