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Wednesday, January 11, 2006

Why is the Yield Curve Flat?

Is this the answer?:

Goldman Sachs Economist May Just Have THE Answer, by John M. Berry, Bloomberg: Why have long-term interest rates hardly budged in the face of 13 increases in the Federal Reserve's target for the overnight lending rate? Economist Bill Dudley of Goldman Sachs has an answer -- maybe THE answer. And if Dudley's view is correct, the flattening of the yield curve over the past 18 months isn't signaling a significant slowdown in U.S. economic growth, much less a near- term recession. Dudley's explanation ... is straightforward:

-- Historically, longer-term interest rates usually have been higher that short-term rates because investors required compensation for expected future inflation, which was likely to be volatile.

-- That calculus has changed because of the Federal Reserve's success in keeping core inflation both low and less volatile.

''The bond risk premium on the 10-year Treasury note is unusually low -- around zero -- when the 10-year yield is compared to expected future short-term interest rates,'' he said. ''Many explanations have been offered to explain the conundrum --including central bank buying of Treasuries and pension fund duration extension. ''But the collapse in the volatility of inflation relative to the volatility of real rates is a much more compelling explanation,'' Dudley said.

Over the past 15 years, volatility of the core personal consumption price index consistently has been much lower than that of inflation-adjusted short-term interest rates. According to Dudley's estimates, inflation volatility last year was less than a fourth of that of real rates. ''This change makes investing in longer-dated fixed-income assets more attractive,'' Dudley said. ''Investors can lock in a stable real rate of return and are subject to little inflation risk.''

On the other hand, buying a series of short-term securities isn't likely to provide a similarly stable real rate of return because the Fed, in an on-going effort to keep inflation low, will raise or lower its short-term rate target as needed. ...

Of course, such an investment decision requires investor confidence that the Fed will continue to control inflation more or less indefinitely. Dudley said he and his colleagues ... believe that the Fed's success under Chairman Alan Greenspan will continue when his successor, Ben S. Bernanke, ... takes over next month.

One consequence of the central bank's success is that it takes a higher Fed target for the overnight lending rate to offset the stimulus flowing from a lower bond risk premium. ''If the bond risk premium falls by 75 basis points, then the average level of short-term interest rates will have to be about 50 basis points higher to offset this,'' Dudley said. And that could mean that the current long string of rate increases ... ''could go somewhat further than anticipated.'' ...

Also ..., two Deutsche Bank economists, Torsten Slok and Christine Dobridge at Deutsche Bank, published a similar explanation for the unusual behavior of long-term rates. Unlike Dudley though, Slok and Dobridge said they expect enough of an increase in inflation that later this year the yield curve would steepen again. ... Their formal modeling also indicated that the yield curve would have to drop much further before it would be pointing to a significant probability of a recession...

I suppose I should note that I said something similar here, but I don't think that this is the whole story for the flattening of the yield curve. Widely cited factors such as the pattern of global saving and investment incentives are also a consideration.

    Posted by on Wednesday, January 11, 2006 at 12:42 AM in Economics, Monetary Policy | Permalink  TrackBack (1)  Comments (17)

          

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    » Economics focus: The (inverted) yield curve from Cultunomics

    As a new edition of the Economist publishes I hold true to my promise of providing a report on the weekly column Economics Focus. This week we are presented with an analysis of the yield curve, whether it is inverted, and its ability to predict the future [Read More]

    Tracked on Wednesday, January 11, 2006 at 07:07 AM


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