Greenspan Casts
Doubt on Import
Of Falling Rates

Federal Reserve Chairman Alan Greenspan said a puzzling decline in long-term interest rates may signal economic weakness ahead, but argued that they aren't as reliable a signal of such weakness as in the past.

Since June 2004, the Fed has raised its short-term rate target to 3% from 1% and has signaled plans to raise it further, while the 10-year Treasury bond yield has fallen to less than 4% from 4.7%. That sort of decline in long-term rates "is clearly without recent precedent," Mr. Greenspan said via satellite to the International Monetary Conference, a meeting of bankers from around the world, in Beijing.

"One prominent hypothesis" for the decline, Mr. Greenspan said, "is that the markets are signaling economic weakness. This is certainly a credible notion." He then cast doubt on it, by noting that "periodic signs of buoyancy" in some parts of the world haven't stopped the decline.

A weakening economy often brings about lower long-term interest rates because it reduces inflationary pressure and demand for credit and leads to inferior returns on competing investments such as stocks. Historically, a decline in bond yields to, or below, the short-term interest rate set by the Fed -- called an "inverted yield curve" -- has been a precursor of economic slowdown or recession. Since the spread between short and long-term rates has narrowed to less than one percentage point from almost three percentage points in the last year, some analysts predict the yield curve will invert.

Fed officials generally have been upbeat on the economic outlook. Mr. Greenspan didn't elaborate on that outlook yesterday and said he didn't know if an inverted yield curve would occur. Responding to questions, he said if it does, "we will not automatically assume it will mean what it meant in the past....The flow of funds has altered in such a dramatic way since the last time we saw that sort of inverted yield curve that I'd be doubtful" its historical meaning could be extrapolated to the present.

As he did in February, Mr. Greenspan went over some of the theories behind low long-term rates and rejected most. Mr. Greenspan said foreign central bank purchases of Treasurys could explain a "modest" amount of the decline in Treasury yields, but not the decline in yields in other countries. Pension funds and insurance companies may be stepping up purchases of long-term bonds to meet the retirement needs of an aging population, but "demographic trends are hardly news." And while a more-global market for goods and services may contain long-term fear of inflation and thus bond yields, he said, "I do not believe it explains the decline...over the past year." He gave the theory that low yields signal weaker growth more credence than in February but still seemed skeptical.

In response to questions, he suggested that the globalization of capital markets is a major factor. Since 1995, he said, investors around the world have been increasingly willing to invest beyond their borders. "I do think the most relevant and likely reason why we're dealing with this is new forces at play in the international market," he said.

Jean Claude Trichet, president of the European Central Bank, concurred, telling the group that inflation-adjusted bond yields in Europe and the U.S. are almost identical now, "a clear demonstration we are living in a single world."

Mr. Greenspan warned that lower government bond yields are encouraging hedge funds and others to take ever greater risks in an effort to boost investment returns but a likely shakeout among them "should not pose a threat to financial stability."

Write to Greg Ip at greg.ip@wsj.com