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Greenspan says no easy answers for long-term rate drop -

Tuesday, June 7, 2005 2:42:49 AM

WASHINGTON (AFX) - The decline of long-term interest rates over the past year despite the Fed's steady tightening remains a conundrum, said Federal Reserve Board chairman Alan Greenspan

"We've never run into anything like this before," Greenspan said at an American Bankers Association conference in Beijing

In his remarks, Greenspan dismissed the four leading Wall Street theories of why global long-term interest rates are so low. "The economic and financial world is changing in ways that we still do not fully comprehend," Greenspan said

Some economists have argued that low rates are signaling economic weakness. But Greenspan said that this argument didn't hold water because "periodic signs of buoyancy in some areas of the global economy have not arrested the fall in rates." Other analysts have argued that the low rates are a function of an aging global population and the investment behavior of pension funds and insurance companies struggling with under-funded retirement plans

"But world demographic trends are hardly news, and recent adjustments to funding shortfalls do not seem large enough to be more than a small part of the complete explanation," Greenspan said

Another popular theory has been that foreign central banks, in particular China, have been heavy buyers of US Treasurys, thus driving down rates

Greenspan said these purchases have lowered rates, but said Fed staff studies have estimated the effect has only been "modest." "Furthermore, such purchases seem an implausible explanation of why yields on long-term non-US sovereign debt instruments are so low," he said

Finally, some economists have pointed to globalization as having a disinflationary effect on the economy with new low-cost producers in China and India and the breakup of the Soviet Union

The Fed chairman said this might explain some of the lower inflation-premiums in long-term rates over the past decade, but doesn't address the decline over the past year

After Greenspan completed his remarks, European Central Bank President Jean Claude Trichet told the low long-term rates might be the result of all of these theories combined

"Small streams make great rivers. Perhaps all these together might explain what we have in front of us," Trichet said

A flip side of the low rates is that investors are taking more risks in search of higher returns, and in many cases are turning to hedge funds

Greenspan repeated his misgivings about hedge funds, saying that much of the easy profits from the sophisticated trading strategies from market inefficiencies may be over

"For the time being, most of the low-hanging fruit of readily available profits has already been picked by the managers of the massive influx of hedge fund capital," he said

As a result, hedge funds may stray into more risky investments as they strive to seek above-average returns

"Significant numbers of trading strategies are already destined to prove disappointing, a point that recent data on the distribution of hedge fund returns seem to be confirming," he said

"Consequently, after its recent very rapid advance, the hedge fund industry could temporarily shrink, and many wealthy fund managers and investors could become less wealthy," Greenspan said

But governments should not rush to restrict the hedge fund industry, he said. Overall, the funds and their innovative strategies have increased economic flexibility by spreading risk

Overall, Greenspan said governments should make sure they preserve the market's flexibility

"In this regard, the recent emergence of protectionism and the continued structural rigidities in many parts of the world are truly worrisome," he said

Greenspan appeared via satellite at an annual central bankers panel discussion sponsored by the International Monetary Conference

Appearing with Greenspan and Trichet were Toshiro Muto, deputy governor of the Bank of Japan and Chinese central bank governor Zhou Xiaochuan