Federal Reserve Chairman Alan Greenspan has been telling an indifferent bond market for the past seven months that slowing inflation is a bigger risk than accelerating inflation.

A Commerce Department report showed the US economy growing at the fastest rate in 20 years that traders put their money where Greenspan's mouth is.

For the first time since July 2, the gap between 10-year and two-year Treasury notes, a gauge of how much extra yield investors demand to take on inflation risk, narrowed to 2.29 percentage points on November 28. The spread was 2.33 points on December 4.

While gross domestic product (GDP) grew 8.2 per cent in the third quarter, price data in the same report showed something else: The personal consumption expenditures price index, a measure of inflation Greenspan favours, rose at a 2.3 per cent annually last quarter, lower than the 2.4 per cent originally reported.

Investors "believe the Fed's commitment to 'win the peace of price stability' is credible," said Paul McCulley, who helps handle about US$100 billion at Pacific Investment Management Co in Newport Beach, California. The gap in yields between 10-year and two-year notes may narrow to 2 percentage points by the end of next year, McCulley said.

Continued growth

The Fed's success in keeping inflation expectations low will keep mortgage and corporate borrowing rates down and help the expansion continue until the end of next year.

While traders have been betting all year that the Fed will not boost its target interest rate until the middle of 2004, based on interest-rate futures, relatively high yields on the longest-maturing government notes signalled skittishness about inflation.

As recently as August, when Greenspan suggested that disinflation is a greater risk to the economy, the gap between yields on the 10-year and two-year notes climbed to a record 2.75 percentage points, according to Bloomberg data.

"There is a general sense that there is a lot of excess capacity and that there is still a risk of deflation," said Martin Feldstein, a Harvard economist and president of the National Bureau of Economic Research, the arbiter of US business cycles. Investors, he said, think the Fed "would act if inflation begins to pick up."

20 per cent rates

Investors have not always had such confidence in the central bank. In the 1970s and early 1980s, the Fed's credibility was tarnished by an inflation spiral. Year-over-year inflation hit 14.8 per cent in March 1980.

Paul Volcker, who took over the chairmanship in 1979, had to keep interest rates as high as 20 per cent on the overnight lending rate between banks even as the economy slipped into the longest recession in post-World War II history because bond investors did not believe the central bank was committed to keeping prices steady.

"Global anti-inflation credibility, and the Fed's anti-inflation credibility, have grown" as a result of "better central bank policy" in the United States and around the world, Kenneth Rogoff, a Harvard professor and former chief economist at the International Monetary Fund, said.

Global inflation has dropped from 30 per cent to 4 per cent during the past 10 years, Rogoff wrote in a study delivered to central bankers in September at the Kansas City Fed's annual conference in Jackson Hole, Wyoming.

'Stunning' data

"Whatever the explanation of global disinflation, the raw data are stunning," he wrote.

Another measure of inflation, the consumer price index, rose 2 per cent in October from a year earlier, down from 2.3 per cent in September, Labour Department figures showed in October.

The US central bank has also been helped by US companies taking advantage of low-cost labour centres like China, which has delivered a "competitive shock" to prices of manufactured goods, said Nobel prize-winning economist Robert Mundell, who is a professor at Columbia University in New York.

Low inflation may also be "due to the expectations of rising productivity as a result of the inexorable information technology deepening and widening," Mundell said, responding to questions about the economy.

Productivity gains

The US Labour Department said on December 3 that productivity grew last quarter by 9.4 per cent, the fastest pace in 20 years. Rising productivity, or the amount of output per hour, eases inflation pressure because companies can meet growing demand without increasing costs.

Since the GDP revision, bond investors have seen a rash of other reports confirming the economy's strength: Orders for durable goods rose 3.3 per cent in November, the strongest in 15 months, and the Institute for Supply Management's factory index surged to the highest level in almost two decades.

Still, inflation expectations have eased, as measured by the difference in yield between 10-year Treasuries and Treasury inflation-protected securities of similar maturity. The spread narrowed to 2.36 percentage points from 2.41 percentage points on November 3.

"There's no imminent danger of inflation," said William Fitzgerald, head of fixed income at Nuveen Investments in Chicago, which oversees US$54 billion of bonds.

Lower expectations

As investors are "collecting information and listening to Fed officials, they are starting to lower their expectations" for a first-quarter interest-rate increase from the Fed, Fitzgerald said. "This is going to cause the market to rally."

Interest-rate futures show traders expect the Fed to gradually increase rates by the second half of next year to restore the overnight lending target to a level more in balance with the supply and demand for money in the economy and to head off any potential future inflation.

"The Fed will follow the markets and not lead them," said Richard Waugh, managing director at Principal Global Investors in Des Moines, Iowa, with about US$65 billion in fixed-income assets under management. "The economic numbers will say rates should go up, investors will start to anticipate interest rates going up and then they will anticipate" a higher Fed target.

Twelve of the 22 economists at bond firms that trade with the Fed, known as primary dealers, said strength in the economy will enable the central bank to drop its statement that rates can remain low for a "considerable period."

Economists at some of the primary dealers said the Fed's policy of leaving rates low will accelerate inflation.

Fed signal needed

"The longer we run at 1 per cent interest rates, the more distortion starts cropping up in the economy," David Malpass, chief global economist at Bear Stearns & Co in New York. Policy makers should send a signal that "they aren't intending to allow inflation to start up in the economy."

Malpass said he expects the Fed to raise its target interest rate as early as March.

Fed officials have not indicated any concern about accelerating inflation anytime soon.

San Francisco Fed President Robert Parry, a voting member of the Fed's Open Market Committee, said after the recent report on third-quarter growth that the economy can expand for "more than a few quarters" before working off unused capacity, in a speech to the Rotary Club of Portland.

"The inflation rate, which is already down to one and a quarter per cent, may slip even lower, despite rapid economic growth," Parry said.

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