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 week ago.)

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 have declined. 

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 over time. 

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 decline.    

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.


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