Santomero speaks: the Philadelphia Federal Reserve President takes on inflation, interest rates, and the future of the American economy. A TIE exclusive interview.

• Position: Interview - Interview

TIE: Let's begin with the whole concept of a neutral Fed funds rate. I'm sure you're aware of the huge debate about where the neutral rate falls--in the 5 percent range or the 3 percent range and so forth--a debate made more complex by questions such as how strong productivity is, and what the historical trends are. A number of the other Federal Reserve Bank presidents and governors have shared their views on this, and we were wondering where you stand?

Santomero: I don't view neutral as a number, but rather as a path through time. The main issue is the state of the economy and demand/supply relationships, and therefore the true question is, where does the interest rate need to be in that context? Accordingly, I view the neutral rate as being dependent upon many factors that change through time, such as technology, savings, and the demand/supply relationships in both the government and foreign sectors. More specifically, one would expect that the level of interest rates that would be defined as neutral in the late 1990s would be higher than it would be in the early part of this decade. We ought to be thinking less about a single number and more about where the interest rate should be given what's going on in the economy at a particular point in time. That's why you haven't seen me opine on a single number because it's the wrong way of thinking about the problem.

TIE: The Fed has clearly communicated that the economy seems balanced now and on a more sustainable path, and therefore rates should be normalized. But as you said, you shouldn't really focus on a rate anyway because the notion of neutral is somewhat of a theoretical construct. How do you know when you've normalized the situation?

Santomero: That's a fair follow up question. There are a couple of ways of thinking about the process. What do we know about this rate even though it may move around? Can we scale it, if you will? We know historically that the neutral rate has been positive and therefore in the early phases of this recovery our rate was clearly stimulative. We know that as the economy goes through its recovery and then expansion, the nature of demand shifts, with consumption driven less by low interest rates and more by increases in income. Consequently, interest rates can move to more normal levels as we go forward.

What does that all mean from the point of view of the dynamics of this cycle? It means that early on it was clear that rates were quite low, but as the expansion continues we need to be more data-driven, analyzing how to proceed from here to a more normal interest rate. We should try to extract the stimulation as higher incomes replace low interest rates as the driver of consumption and business investment. So the challenge before us in the fourth year of this expansion is to move the interest rate up even as income and sales are driving domestic spending, and to try to allow the economy to continue to expand somewhat above trend even while we are reducing the stimulation associated with low interest rates.

TIE: The ten-year Treasury bond has performed beyond expectations recently. Very few people at the Fed or anywhere else would have predicted the U.S. bond market to rally each and every time the Fed has tightened short rates during this cycle, causing a flattening of the yield curve.

A couple of theories try to explain this. Some at the Fed say the performance of the bond market is the result of a great deal of savings sloshing around the globe without enough investment opportunities. Others credit the Fed's superb performance in fighting inflation. And others say weakness in the global market may be over the horizon--the rest of the world doesn't look so great, particularly Germany and Japan, with Japan having to revise down its growth numbers. China is essentially a bubble about to burst. The loss of the carry trade is increasing, which could have a negative wealth effect on consumption in the United States. How do you explain why the long bond is where it is today despite all the Fed tightenings?

Santomero: It clearly is true that the rest of the developed economies are growing but could be growing faster. I would welcome a bit more strength in Japan although the recovery there seems to be well in place. I would like to see the Western European economies growing a bit faster although they are improving. And there's been a bit of easing in the growth rate of China from unsustainably high rates to significant growth nonetheless going forward, as best we can tell.

When I look at the long rate and try to figure out what the markets are telling us, I side with the notion that the markets are convinced that the Federal Reserve will take necessary steps to keep inflation well-contained. We used to call that credibility, now we talk about anchored expectations. But it is unusual during a period of Fed tightening to see the five- and ten-year rates move in the direction they have. I believe the market is telling us it understands the Fed's commitment to price stability and sees our movement toward a more normal interest rate environment as consistent with that commitment.

So, from where I sit, it's really a situation of reaffirming the market's expectation that the Fed stands ready in an important way to maintain price stability. The world's liquidity for some time has found its way into the United States a strong economy with strong...