Collender To Bond Market Vigilantes: Just Chill

Here's my column from today's Roll Call.

The Bond Market Vigilantes Need To Chill Out

If you follow the federal budget, the story of Bill Clinton and the bond market has taken on almost mythical qualities.

Based on the advice of Robert Rubin, early in the first term of his presidency Clinton realized that he had to pay attention to the big impact his budget policies were going to have on interest rates. Ever since then, Washington supposedly listens whenever the “bond market vigilantes” speak.

And in recent days they have been increasingly speaking about what should be done about the budget. Supposedly because of their unhappiness with the outlook for federal deficits and government borrowing, interest rates on Treasuries have been rising. This has slowed mortgage refinancing, raised concerned about the ability of would-be buyers to purchase a home and, in general, raised questions about the economy continuing to recover.

At least partly because of the bond market vigilantes, the change in the budget and economic discussions has been astounding.

Two weeks ago the financial and business news channels were complaining loudly about how long it was taking for federal stimulus dollars to be spent. That has now changed to a concern about whether the government should spend the money at all.

Until very recently many of the most highly regarded bond market analysts were saying they weren’t convinced that the more than 30 percent increase in the Dow Jones Industrial Average that has occurred since March was real and were using phrases like “bear market rally” and “dead cat bounce” to explain what was happening. That meant money was continuing to flow into bonds rather than stocks because of what many saw as the continuing risk in equities.

Over the past two weeks, that skepticism seemed to have turned almost 180 degrees as many of the same analysts who previously were astonished when the market had an up day began to express surprise when a rally didn’t continue.

Instead of triggering the triple-digit drop in the Dow that had been typical of the past year, bad news suddenly has the stock market always looking for the pony. As a result, money that had been flowing into bonds from stocks started to move in the opposite direction.

And even though there are few real indications that it’s actually happening, the extreme concern about deflation that had been dominating the economic headlines over the past year has been replaced in the past few weeks by a not-so-subtle worry not just about higher prices but what the vigilantes say will be “roaring inflation.”

To a certain extent all of these changes are a good thing because, at least on Wall Street, there appears to be a growing belief that the economic outlook is improving. Many statistics are being interpreted far more positively now than was the case less than a month ago and that’s having a further positive impact on what investors are thinking and doing.

But for a variety of reasons, it’s far too early for fiscal policymakers to begin to make changes in response to what the bond market vigilantes seem to want.

First, between now and when President Barack Obama’s fiscal 2011 budget is released early next year, the Federal Reserve and monetary policy should be assumed to be in the best position to make a move if one is needed. Not only can that happen far more quickly and have a much faster impact than anything Congress and the White House will be able to do on the budget, the Fed’s primary responsibility is worrying about the inflation the bond market vigilantes have been increasingly talking about in recent weeks. In other words, Congress should let the Fed do its job.

There may be complaints about this from some vigilantes who say that the full impact of a change in interest rates isn’t felt for six to nine months so fiscal policy needs to be changed as well. But we know both from the George W. Bush and Obama stimulus efforts that the impact of budget changes is at least as slow as anything the Fed can do regardless of whether they are checks written to individual taxpayers by the Treasury or checks written by other departments to businesses and local governments. Add to that the time it takes for fiscal stimulus to be enacted compared to speed at which the Fed can act, and it’s clear that the fiscal policy lag is considerably greater.

Second, the unambiguous evidence that the vigilantes seem to be relying on to show that the economic recovery is real and can’t be stopped simply doesn’t yet exist. Last Friday’s unemployment report was indeed much better than expected and gross domestic product for the first quarter of 2009 was revised upward. But better doesn’t mean good; more than 300,000 jobs were lost last month and economic activity declined by more than 5 percent. In other words, no matter how much Wall Street may want to find a pony in that pile, there’s really no doubt that it still smells.

Changing fiscal policy now would be the Obama equivalent of Bush landing on an aircraft carrier and declaring “mission accomplished” when the war is anything but over.

The vigilantes are right in one very important respect: Washington’s fiscal policymakers definitely need to know that the deficit and government borrowing will be big issues for the bond market at some point. They are right to push for future fiscal restraint now so that it becomes as much of a foregone conclusion as is possible in Washington when the time comes.

The key, though, is for Congress and the White House not to move prematurely. Assuming the economy continues to improve as many forecasters are projecting, the fiscal 2011 budget that will be considered next year definitely should include at least the fiscal restraint that is already planned.

Until then, the bond market vigilantes need to let the recovery happen. If they don’t, they may find that the importance they were given by Rubin and Clinton will change from mythical to myth.