Bernanke's Yield-Curve Confusions
By Frank Shostak
In his speech on March 20 the new Fed Chairman Ben Bernanke admitted that he is not so sure whether the Fed should be tightening its stance further or whether the central bank should pause. The reason, according to Bernanke, is the unusual behavior of long-term interest rates.
Despite a visible increase in the federal funds rate from 1% in June 2004 to the current figure of 4.75%, the yield on the 10-year T-Note rose only slightly. At the end of March the yield stood at 4.74% against 4.58% at the end of June 2004.
The Fed Chairman has concluded that the consequent narrowing in the spread between the long-term and the short-term interest rates (flattening in the yield curve) may imply that the present interest rate stance of the U.S. central bank is either too easy or too tight. It all depends, he says, on the type of expectations that investors hold.
According to Bernanke, there is a possibility that the premium on long-term interest rates may have fallen. Now, if this is the case then this could mean that investors expect an improvement in the future economic environment – more stable inflation and a reduction in economic volatility. This is likely to set the platform for stronger economic activity in the months ahead. Hence, in his view and contrary to past experience, the present narrowing in the spread between the long-term and the short-term interest rates is likely to stimulate aggregate demand. Stronger economic activity in the months ahead, according to this way of thinking, means that the Fed must be more watchful as far as inflation is concerned. All this in turn implies that the Fed ought to maintain its present tight monetary stance.
Bernanke also raised the possibility that the narrowing in the yield spread could be due to expectations that short-term interest rates are likely to fall in the future as a result of a possible economic slowdown or a recession. If this is the case, the U.S. central bank should not proceed with its present tighter interest rate stance. The Fed chairman doesn’t however assign very high likelihood to this scenario because both short- and long-term rates are relatively low by historical standards.
To confuse things further, Bernanke has suggested that the real interest rate, which is consistent, with a stable economy (also known as the neutral interest rate) may have declined. Bernanke attributes the possible fall in the neutral rate to the world glut of savings, among various other causes. Now if this is correct, the current level of the fed funds rate may be too high. This means that the Fed should reverse its tight stance to prevent deflationary pressures.
Observe that for Bernanke whenever the federal funds rate is below the neutral rate this generates inflationary pressure since aggregate demand exceeds aggregate supply at the lower federal funds rate. Conversely, whenever the federal funds rate is above the neutral rate this sets in motion downward pressures on the prices of goods since at a federal funds rate above the neutral rate aggregate supply exceeds aggregate demand.
Investors’ expectations and the shape of the yield curve
Historically since the 1950s the narrowing in the differential between the 10-year and the three-month Treasury note preceded most recessions in the United States. This narrowing in the spread has occurred many months before the onset of the recession. The most popular explanation of the causes that determine the shape of the yield curve is provided by the expectation theory (ET). The key to the shape of the yield curve is that long-term interest rates are the average of expected future short-term rates.
If today’s one-year rate is 4% and next year’s one-year is expected to be 5%, the two-year rate today should be (4+5)/2 = 4.5%. It follows then that expectations for increases in short-term rates will make the yield upward sloping, for long-term rates will be proportionately higher than short-term rates.
Conversely, expectations for a decline in short-term rates will result in a downward sloping yield curve, for long-term rates will be proportionately lower than short-term rates. (Thus if today’s one-year rate is 5% and next year’s one-year is expected to be 4%, the two-year rate today (4+5)/2 = 4.5% is lower than today’s one year rate of 5% – downward sloping yield curve).
According to the practitioners of ET, an economic slump is associated with falling interest rates. Consequently, whenever investors expect an economic slowdown or a recession they shift their money from short-term securities towards long-term bonds. This shift raises short-term rates and lowers long-term rates, i.e., narrowing in the spread or the inversion in the yield curve emerges. (Again note that because at present both short- and long-term rates are relatively low by historical standards, Bernanke doesn’t accept that this time around the flattening in the curve points to an economic slowdown or a recession).
Conversely, an economic expansion is associated with rising interest rates. Hence whenever investors expect economic expansion they shift their money to short-term securities away from long-term bonds. This shift leads to the lowering of short-term yields and an increase in long-term yields.
But is it possible to have a sustained downward sloping yield curve? One can show that in a risk-free environment, neither an upward- nor a downward-sloping yield curve can be sustainable.
An upward-sloping curve will provoke an arbitrage movement from short maturities to long maturities. This will lift short-term interest rates and lower long-term interest rates, i.e., leading towards a uniform interest rate throughout the term structure. Arbitrage will also prevent the sustainability of an inverted yield curve by shifting funds from long maturities to short maturities thereby flattening the curve. On this Mises argued:
“The activities of the entrepreneurs tend toward the establishment of a uniform rate of originary interest in the whole market economy. If there turns up in one sector of the market a margin between the prices of present goods and those of future goods which deviates from the margin prevailing on other sectors, a trend toward equalization is brought about by the striving of businessmen to enter those sectors in which this margin is higher and to avoid those in which it is lower. The final rate of originary interest is the same in all parts of the market of the evenly rotating economy.”
Now, in a free, unhampered market economy the tendency toward the uniformity of rates will only take place on a risk-adjusted basis. Consequently, the yield curve that includes the risk factor is likely to have a gentle positive slope. It is, however, difficult to envisage a downward sloping curve in a free unhampered market economy – since this would imply that investors are assigning a higher risk to short-term maturities than long-term maturities, which doesn’t make sense.
Even if one were to accept the rationale of ET for the changes in the shape of the yield curve, these changes are likely to be of very short duration on account of arbitrage. (Individuals will always try to make money regardless of the state of the economy). Yet historically either an upward-sloping or a downward-sloping yield curve held for quite a prolonged period of time.
The Fed and the shape of the yield curve
While the Fed can exercise a control over short-term interest rates via the federal funds rate, it has less control over longer-term interest rates. It is this that gives rise to an upward or a downward sloping yield curve. An upward or downward sloping curve develops on account of the Fed’s monetary policies that disrupt the natural tendency towards the uniformity of interest rates along the time structure.
For instance, the artificial lowering of short-term interest rates, which is set in motion by the increase in monetary expansion gives rise to an upward sloping yield curve. This upwardly sloping curve (in excess of the slope that allows for the risk factor) cannot be sustained since it sets in motion forces that are working toward the flattening of the curve.
An easy monetary stance prompts investors to borrow money at lower short-term interest rates and invest in higher-yielding longer-term investments. This in turn puts upward pressure on short-term rates and downward pressure on long-term rates. To sustain the positive-sloping curve, the Fed must persist with its easy stance. (Should the central bank cease with its monetary pumping, the shape of the yield curve will tend to flatten). The loose monetary policy of the Fed gives rise to various activities that prior to loose policy were never on the cards – an economic boom emerges. (The loose monetary policy leads to a shift of real funding away from wealth-generating activities and toward less profitable activities).
Whenever the Fed reverses its stance by slowing its monetary expansion and, in the process, raises short-term interest rates, various activities that emerged on the back of the previous loose stance are now coming under pressure – and this sets in motion an economic bust. A tighter stance manifests itself through a flattening or an inversion of the yield curve. In order to sustain the narrowing in the yield spread the central bank must maintain its tighter stance. For should the Fed abandon the tighter stance the tendency for rates equalization will arrest the narrowing in the spread or arrest the inversion of the yield curve.
We can thus conclude that the shape of the yield curve is set, if indirectly, by the central bank. Investors’ expectations can only reinforce the shape that was set by the Fed. For instance, ongoing monetary expansion that keeps the upward slope of the yield curve intact ultimately fuels inflationary expectations, which in turn tend to push long-term rates higher and thereby reinforcing the positive slope of the curve. Conversely, an emerging recession on account of a tighter stance lowers inflationary expectations and reinforces the inverted yield curve.
Whenever the Fed reverses its monetary stance, which manifests itself through the change in the shape of the yield curve, the effect of this change in the stance doesn’t assert itself immediately on the entire economy. The effect of a change in monetary policy shifts gradually from one market to another market. It is this that prompts the change in the shape of the yield curve to be seen as a leading indicator of economic activity.
For instance, when during an economic expansion the Fed raises the fed funds rate target, which causes the narrowing in the yield spread, the initial effect is minimal for economic activity is still dominated by the previous easy monetary stance. It is only later on, once the tighter stance begins to dominate the scene, that economic activity begins to weaken.
Notwithstanding Bernanke’s view, we can conclude that the currently observed flattening or near inversion of the yield curve is an indication of a tighter Fed stance that is likely to undermine various activities that sprang up on the back of the previous easy monetary policy. In short, a flattening or the inversion of the yield curve is likely to result in an economic slowdown.
This conclusion is also supported by the visible fall in the growth momentum of money AMS. Our monetary analysis indicates that the growth momentum of economic activity, as depicted by real GDP is likely to weaken visibly in the months ahead. In fact the yearly rate of growth in Q4 is forecast to fall to 2.4% from 3.2% in Q4 last year. Given the possibility that the micro-foundation of the US economy is severely dislocated on account of the previous aggressive lowering of interest rates by the Fed, it will not surprise us if the economic slowdown is going to be much more severe than what we currently envisage.
To conclude, contrary to the expectation theory (ET) that the chairman of the Fed utilizes in his analysis, the inversion of the yield curve has nothing to do with expectations as such but comes about on account of the Fed’s tighter stance. This in turn means that economic activity is likely to ease in the months ahead.