WSJ: Bond Market Tonic

Wall Street Journal ^ | September 22, 2004 | Editorial

[OESY]

...While claiming that inflation expectations have eased in the last few months, the Fed Governors believe the U.S. economy has a healthy head of steam, in contrast to bond traders who have been betting that last spring's "soft patch" would persist.

Certainly there is ample evidence that the Fed is correctly recognizing the strength of this expansion. Manufacturing output is increasing at a 6.7% annual rate, and we now know that in the second quarter corporate investment overtook cash flow, a key indicator of confidence in the future. This despite the run-up in oil prices that would ordinarily be a millstone dragging down the economy....

But when the overnight price of money rises and the long-bond rate falls, that says something else to us: effective policy. Realizing that the Fed has established a solid commitment to nipping inflation in the bud reassures lenders that the value of their investment will be protected. That's the best tonic for the bond market.

In fact, it's far more important than that other bugaboo bond traders sometimes fret over, the deficit. The former Clinton advisers now surrounding John Kerry are raising the alarm that the record budget shortfall this year will mean higher borrowing costs ahead, but there's zero evidence that's true. In fact, long-term interest rates are now lower than they were in the late 1990s when the Clinton Administration was running a surplus.

[I]nflation is primarily a monetary phenomenon, which is why it's critical that the Fed concentrate on the goal of price stability. The best evidence so far is that the Fed is on the right track, whether or not you believe as we do that the Governors were late to spot rising inflationary expectations earlier this year. The most important thing now is that they stay the course.