There’s no “Conundrum”

As recounted by Greenspan in chapter 20 of his memoir “The Age of Turbulence”:

“What is going on? I complained in June 2004 to Vincent Reinhart, director of the Division of Monetary Affairs at the Federal Reserve Board. I was perturbed because we had increased the federal Funds rate , and not only yields on ten-year treasury notes failed to rise, they’d actually declined. It was a pattern we were accustomed to seeing only late in a credit-tightening cycle, when long-term interest rates began to fully reflect the lowered inflation expectations that were the consequence of the Fed tightening. Seeing yields decline at the beginning of a tightening cycle was extremely unusual.”

The chart illustrates:

However, just a few years before, and not much talked about, the reverse situation happened:

On December 29, 2000, the yield on 10-year U.S. Treasury securities was 5.12 percent. Within a week of that date, the Federal Open Market Committee convened a rare unscheduled meeting and implemented the first in a rapid-fire string of 11 reductions in the federal funds rate. By the middle of 2002, the funds rate was a full 475 basis points lower than at the beginning, marking one of the largest declines in the Fed Funds rate in history. Very-short-term market rates also fell, but there was scant impact on long-term interest rates.

Do these facts indicate that monetary policy has become less effective? According to conventional wisdom (as expressed by Greenspan) reducing or increasing the Fed Funds rate by the magnitude experienced in both episodes should have had some impact on longer term interest rates.

Paradoxically, precisely because monetary policy was so effective that long rates almost didn´t budge as short rates plunged (and increased). The effectiveness of monetary policy is ultimately measured by the central bank’s ability to provide nominal stability (which most understand to mean stable inflation) in which case inflation expectations remain stable.

The whole 2001 – 2006 period saw a policy environment that continued to deliver the expectation of stable inflation, and hence one in which the behavior of market interest rates more generally were wholly determined by developments in the real economy.

The charts illustrate the idea. Throughout, long-term inflation expectations remained stable, and so did long-term yields.

In fact, the yield curve that prevailed just before the 2001 “loosening cycle” began and the one at the end of the “tightening cycle in mid-2006 are almost indistinguishable.

What about now? Since 2014, we see a Fed that´s geared to “tightening”, first implicitly, by means of words (the “tightening talk”) and since late 2015 explicitly, by raising rates, and promising to continue to do so.

Again, long-term rates have remained relatively stable, simply because long-term inflation expectations have done the same.

In other words, the Fed has succeeded in maintaining nominal stability. But surely, the present “nominal stability” is of a different nature than the one obtained in the earlier period. What jumps out is the different levels that characterize the present stability. They are “too low”! In fact, those levels are consistent with the view held by some of a “secular stagnation”. I would venture that´s a “false stability”, one that can be easily lost by the slightest “perturbation

Yellen hasn´t yet uttered the word “conundrum”, which doesn´t mean she´s not thinking about it. The November election, by changing perceptions of what could be, gave a lift to long-yields and inflation expectations. But that appears to have been ephemeral, and downward pressures on inflation expectations and long yields are coming back.

If the Fed insists on its present course of action, expect inflation expectations, actual inflation, long bond yields, the dollar, the stock market and output growth to recoil!

John Williams of the San Francisco Fed, for example, very recently discussed Speed Limits & Stall Speeds. His conclusion is amazing:

Our goal, therefore, is to foster sustainable growth. This requires keeping our economy in the Goldilocks zone: not too hot, not too cold. It also necessitates bringing both conventional and unconventional monetary policy back to normal … our process has been widely telegraphed and it will continue to be gradual, predictable and transparent … my new mantra is: ‘Boring is the new exciting.'”

The economy is much closer to “stall speed” than he realizes so, soon, “boring” could become very “exciting” indeed.

[Note: Inflation Expectations are those estimated by the Cleveland Fed. A non-technical summary can be read here]


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