WASHINGTON – The blame game in the wake of the bloodiest U.S. bond market rout in nearly a decade is in full swing and many of the fingers are pointed at the Federal Reserve (search).
Accusations are flying that the central bank overplayed its concerns on deflation in a manipulative effort to push long-term interest rates lower to goose the economy.
Now the Fed has been "caught out" -- as Melvyn Krauss of the Hoover Institution put it in an opinion piece in the Wall Street Journal Friday -- some argue its credibility has been damaged.
"The Fed whipped up a positive frenzy about deflation," said James Grant of Grant's Interest Rate Observer (search). "To my mind not the least of the sins of the Fed in this period was its cavalier willingness to suppress, manipulate and distort what had been more-or-less free prices."
But other analysts say misplaced market bets in the rally that preceded the meltdown may have been more the result of an unusually open Fed debate and a complex policy message than an intention to deceive.
"The Fed didn't set out to consciously screw over markets," said Adam Posen, a former New York Fed researcher now with the Institute for International Economics (search).
"Because the Fed is moving to a more transparent regime and therefore is communicating when things are uncertain or when things are contingent, they are more open to being accused of being inconsistent," he said. "People are just not ready to deal with that yet."
The roots of the current schism trace back to November when Fed officials first began to speak of how they could ward off a potentially crippling decline in consumer prices in the event they ran out of room to cut short-term interest rates.
The then-listless economy had the Fed preparing to cut overnight rates to a fresh four-decade low of 1.25 percent.
Officials have said their exploration of how best to fight deflation was merely prudent due diligence and their frequent public discussion over alternative policy tools, such as buying Treasury bonds to pull long-term rates down, was simply an effort to educate markets and the public.
As talk about unusual deflation-fighting steps reached a crescendo in mid-June, the yield on the benchmark 10-year Treasury note touched a 45-year low of 3.07 percent.
But when the Fed met later that month, it cut short-term rates by a modest quarter point and made no reference to the possibility of departing from traditional policy tools.
That June 25 decision disappointed investors who had bet the Fed was edging toward buying Treasury bonds -- and the selling began.
Things got uglier in mid-July when Alan Greenspan made the central bank's thinking plain: if further stimulus was needed, overnight rates would be the tool. He told Congress chances were slim the Fed would need turn to other measures.
The selloff did not cool until last week, after the yield on the 10-year Treasury note nearly reached 4.6 percent. The yield now is hovering above 4.2 percent.
"Price action in the last few weeks reveals that the bulk of the pupils flunked the mid-term exam," economists at Credit Suisse First Boston wrote after Greenspan's testimony. "When the bulk of the pupils fail the test, we are inclined to assign considerable blame to the teacher."
Former Fed governor Lyle Gramley agrees the Fed has had trouble communicating but disagrees with those who say the central bank's credibility with the markets is shot.
He said the biggest problem was that the Fed's current message has mixed implications for bonds. It plans to keep short rate low for a prolonged period -- a bond positive -- but it wants to push up a too-low inflation rate -- a negative.
"The Fed is in uncharted territory here, so is the market, and trying to communicate the message and getting it correct is inherently very difficult in these circumstances," he said.