February 23, 2005
According to Federal Reserve Chairman Alan Greenspan,
declining interest rates on longer term maturities when short term interest
rates are beginning to rise is a “conundrum.”
(that means “riddle” or “puzzle” for those who have not
studied recently for their college boards.)
Historically, interest rates on longer term maturities
tend to rise along with overnight rates, at least early in the cycle of
rising short term rates. In
1993-1994 for instance, yields on ten year government bonds rose 1.5
percentage points during the initial 1.5 percentage point rise for federal
funds rates. However, during
the second 1.5 percentage point rise in the funds rates, long term yields
actually fell a bit.
In this rising short term rate cycle, the increase
in yield on ten year government bonds
was less than a percentage point before almost the entire increase
was reversed in the past half year. While
this rate pattern certainly is not normal, is it really the puzzle the
Chairman claims. (By the way, right after the Chairman expressed his surprise,
bond investors decided that the “conundrum” should disappear.
Long term mortgage rates now are almost a quarter point higher than a
Three explanations have been provided for this unusual
interest rate behavior, and Greenspan touched on all three in his testimony.
First, long term rates could fall if investors backed
away from economic activity as short term rates fell. This would cause a recession.
Indeed, one of the strongest early warning signs that a recession is
looming occurs when short term rates rise above long term rates.
In short, the yield curve (the difference in rates between short and
long term maturities) could be indicating that economic slowing is ahead.
The Chairman answered this by first presenting the
Federal Reserve forecast of growth in this year’s four quarters equal to
or slightly ahead of the 3.7 percent growth of a year ago.
However, he also noted that the stock market remained strong (another
signal of future economic activity) and that lower grade bond credits had
experienced yields falling even more rapidly than treasuries.
If investors thought the economy was about to weaken,
they would be running away from lower grade bonds, not toward them.
Second, investors might believe that future inflation
would be lower than they previously expected.
As expectations of deflation existed less than two years ago, it is
hard to believe that expected inflation is lower now than then.
Nevertheless, Greenspan cited several relevant bits of evidence to
support this explanation.
The Federal Reserve forecast for inflation was about
the same 1.5 percent to 1.75 percent excluding food and energy that occurred
in the past year. If growth is
good but forecasted inflation is not rising, then expected inflation may
Furthermore, the yield on inflation adjusted government
bonds has declined, suggesting that expected inflation may have eased.
(It might also indicate that expected real rates have fallen.
After all, Greenspan acknowledged that productivity, a factor in
those returns, was slowing.)
Third, international savings have continued to flow to
our shores despite their already large dollar holdings and despite a weak
dollar. Greenspan did not use
my argument that trade surpluses were growing fastest in the countries that
traditionally invest in U.S. government, but he could have.
He probably hesitated because he knew that such traditional behavior
does not persist indefinitely.
Thus, if international flows are the cause of the
conundrum, that problem would disappear through rising longer term rates
While Greenspan’s arguments certainly have merit, there is a serious question about whether observed interest rate behavior is a puzzle.
In our economics courses, we teach about “the” interest rate. In fact, there are a whole bunch of rates that differ by credit quality and length of holding period among other more exotic conditions if the bonds are sliced and diced by Wall Street purveyors.
Most rates have a relationship to over-night money but
they are not readily bought and sold by the Federal Reserve.
However, federal funds rates are where the Federal Reserve can have
significant input. If the Federal Reserve begins chasing inflation (is late in
Wall Street parlance), then both short and long term rates rise until
inflation stabilizes and begins to recede.
At that point, short term rates may rise further but long term rates
On the other hand, if the Fed is ahead of the inflation curve, then rising short term rates soon will stabilize or reduce long term rates, as is currently happening. To be sure, the Fed must be careful not to raise rates too high, but those lower credit yields will provide plenty of early warning by rising ahead of other rates. Until that happens, what the Fed is doing appears to be the right course for this economy.