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May 18, 2006
Poole (And Haubrich) On The Yield Curve
Federal Reserve Bank of St. Louis president William Poole weighed in today on whether we should care about the spread between long-term and short-term interest rates and, if so, why? If you are new to the topic it is a nice enough introduction, but there is also plenty there for people who have thinking about the topic for awhile. What I found interesting was his take on why the yield curve -- yield curve "inversions" in particular -- may have been more informative back in the day:
Many of the inversions of the yield curve starting in the 1960s occurred under the old deposit interest rate ceilings established under Regulation Q. The ceiling on the deposit rate led to “disintermediation” from the banking system when monetary policy tightened and increased the responsiveness of the quantity of money inside the banking system to Federal Reserve policy actions. However, there was no inversion associated with the recessions of 1957-58 and 1960-61. Before the mid 1960s, the Fed adjusted Regulation Q interest ceilings in a fashion timely enough to prevent significant disintermediation.
In an environment of slow adjustment of Reg Q ceilings, when the Fed stepped on the monetary brakes, bank credit became tight and the real short-term interest rate quickly rose well above its equilibrium level. Because the market anticipated that the monetary brakes would be loosened within a relatively short time frame, long-term interest rates rose by a much smaller amount, and the yield curve inverted temporarily. It was during this era that yield-curve inversions came to carry negative business-cycle connotations. All too often, the clampdown on credit was severe enough to be associated with a recession but not steadfast enough to bring about lasting disinflation.
In a recent Cleveland Fed Economic Commentary, my colleague Joe Haubrich offered a different, though perhaps complementary, explanation for why the predictive power of the yield curve may have faded over time:
... a more credible regime means less persistent inflation: The Fed stops inflation quickly once it starts, and so inflation is only temporarily high. In a less credible regime, once high inflation begins, it stays around, and the monetary authority does little or nothing to stop it.
In the case of the less credible regime, inflation shocks will tend to shift up both short- and long-term interest rates, as inflation feeds through to both. Thus, with persistent inflation, nominal shocks don’t shift the yield curve’s slope very much—both long and short rates move together. Now suppose that these inflationary expectations aren’t the part of the yield curve that predicts real activity. That is, the real part of the yield curve, interest rates adjusted for inflation, is what predicts real activity. Then, under a less credible regime, nominal shocks don’t distort the curvature of the yield spread, and inversions can signal recessions.
Under a credible regime, with low persistence of inflation, it is a different matter. In this case, an inflation shock will increase short rates, but not long rates, because long-term expectations of inflation don’t change. Thus a nominal shock twists the yield curve, distorting the message of the underlying real curve. This pattern seems to hold—at least for the United States; times of high inflation persistence are also times when the yield curve predicts well. In times of low persistence (like in the present, credible regime), the yield curve does less well.
Poole concludes that any present concerns about the short-term/long-term spread are much ado about not much:
I must say that I’ve been a bit puzzled by the inversion/recession talk that began last fall. As already noted, the spread between the 10-year bond and the fed funds never became negative last fall and still isn’t. Yet, inversions associated with recessions have been quite large... looking back at 1980-82 experience makes clear that simply counting presumed patterns in the data, without guidance from economic theory, is not a wise strategy. The early 1980s were so different from today’s conditions in so many respects that the experience of twin recessions in a high inflation era has little bearing on understanding the term structure today.
Joe, I would guess, doesn't disagree all that much, but does suggest we not entirely discount the yield curve's history:
Using the yield curve remains an exercise in judgment that requires balancing the long, successful history of the yield curve’s predictive power with some recent evidence of its fading foresight. It also requires judgment because predictions of real activity represent only one facet of the problem facing the FOMC: Inflation is the other. Still, as the Committee becomes more familiar with the risk-management approach to policymaking, it seems that the signal from the yield curve deserves some weight.
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