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Monday, March 20, 2006

Bernanke: The Yield Curve and Monetary Policy

Ben Bernanke discusses why long-term interest rates have remained low throughout the Fed's current tightening cycle and the implications of this for monetary policy. He notes two main explanations for low long-term rates, and he discusses why the monetary policy implications differ according to which explanation is adopted. If low long-term rates are due to a decline in the term premium, the effect is  stimulative and policy would need to be tightened. But if low long-rates are due to current or anticipated economic conditions, e.g. an anticipated slowdown in growth in the future, the implications for policy are the opposite. Tim Duy will have a Fed Watch later, so for now here's a shortened version of Bernanke's remarks:

Reflections on the Yield Curve and Monetary Policy, by Chairman Ben S. Bernanke, March 20, 2006: ...I intend to ... address an intriguing financial phenomenon: the fact that, over the past seven quarters or so, tightening monetary policy has been accompanied by long-term yields that have moved only a little on net. Why have long-term interest rates not risen more...? And what implications does this ... have for monetary policy and the economic outlook? As you will see, in my remarks I will do a better job of raising questions than of answering them. ... I will conclude that the implications for monetary policy ... are not at all clear-cut. ...

Why have the far-forward rates implied by the term structure of interest rates declined in recent years? Observers have offered two broad (and not mutually exclusive) classes of explanations. One set of explanations holds that bond yields are reacting to current or prospective macroeconomic conditions. Another set focuses on special factors that may have influenced market demands for long-term securities ... independent of the economic outlook. I will first consider explanations that emphasize possible changes in the net demand for long-term securities...

According to several of the most popular models, a substantial portion of the decline in distant-horizon forward rates over recent quarters can be attributed to a drop in term premiums. ...[W]e can ... divide the term premium into two parts--a premium for bearing real interest rate risk and a premium for bearing inflation risk. Both of these components have trended lower over time..., but the decline ... appears to have been associated mainly with a drop in the compensation for bearing real interest rate risk.

At least four possible explanations have been put forth for why the net demand for long-term issues may have increased, lowering the term premium. First, longer-maturity obligations may be more attractive because of more stable inflation, better-anchored inflation expectations, and a reduction in economic volatility more generally. ... if investors have come to expect this past performance to continue, they might believe that less compensation for risk ... is required...

A second possible explanation ... is linked to the increased intervention in currency markets by a number of governments, particularly in Asia. ... This interpretation has some support... However, ... Several pieces of indirect evidence suggest that the long-term effect of foreign purchases on yields may be moderate...

Changes in the management of ... pension funds are a third possible source of a declining term premium. Reforms ... expected to encourage pension funds to be more fully funded .... Together with the increased need of aging populations in the industrial countries to prepare for retirement ... may have increased the demand for longer-maturity securities. We have seen little direct evidence to date of sizable pension-fund portfolio shifts toward long-duration bonds, at least in the United States. But ... bond investors might be attaching significant odds to scenarios in which pension funds tilt ... their portfolios toward such assets substantially over time.

Fourth and finally, as investors' demands for long-duration securities may have increased over the past few years, the supply of such securities seems not to have kept pace. ...

What does the historically unusual behavior of long-term yields imply for the conduct of monetary policy? The answer, it turns out, depends critically on the source of that behavior. To the extent that the decline in forward rates can be traced to a decline in the term premium, ... the effect is financially stimulative and argues for greater monetary policy restraint, all else being equal. ...

However, if the behavior of long-term yields reflects current or prospective economic conditions, the implications for policy may be ... quite the opposite. The simplest case in point is when low or falling long-term yields reflect investor expectations of future economic weakness. ...

What is the relevance of this scenario for today? ... I would not interpret the currently very flat yield curve as indicating a significant economic slowdown to come, for several reasons. First, in previous episodes when an inverted yield curve was followed by recession, the level of interest rates was quite high... Second, ... to the extent that the flattening or inversion of the yield curve is the result of a smaller term premium, the implications for future economic activity are positive rather than negative. Finally, the yield curve is only one of the financial indicators that researchers have found useful in predicting ... economic activity. Other indicators ... would seem to be consistent with continuing solid economic growth. ...

An alternative perspective holds that the recent behavior of interest rates does not presage an economic slowdown but suggests instead that the level of real interest rates consistent with full employment in the long run--the natural interest rate, if you will--has declined. For example, ... factors that may create a longer-term drag on the growth in household spending, including high energy costs, the likelihood of slower growth in house prices, and a possible reversal of recent declines in saving rates. If these drags on the growth of spending do materialize, then a lower real interest rate will be needed to sustain aggregate demand.... To be consistent with a lower long-term real rate, the short-term policy rate might have to be lower than it would otherwise be as well.

Given the global nature of the decline in yields, an explanation less centered on the United States might be required. About a year ago, I offered the thesis that a "global saving glut"--an excess ... of desired global saving over desired global investment--was contributing to the decline in interest rates. In brief, I argued that this shift reflects the confluence of several forces. On the saving side, the factors include rapid growth in high-saving countries on the Pacific Rim, export-focused economic development strategies that directly or indirectly hold back the growth of domestic demand, and the surge in revenues enjoyed by oil producers. On the investment side, notable factors restraining the global demand for capital include the legacy of the Asian financial crisis of the late 1990s, .., and the slower growth of the workforce in many industrial countries. So long as these factors persist, global equilibrium interest rates (and, consequently, the neutral policy rate) will be lower than they otherwise would be.

What conclusion should we draw? Clearly, bond prices, like other asset prices, incorporate a great deal of information... However, the information is not always easy to extract and--as in the current situation--the bottom line for policy appears ambiguous. In particular, to the extent that the recent behavior of long-term rates reflects a declining term premium, the policy rate associated with a given degree of financial stimulus will be higher than usual. But to the extent that long-term rates have been influenced by macroeconomic conditions, including such factors as trends in global saving and investment, the required policy rate will be lower. Given this reality, policymakers are well advised to follow two principles familiar to navigators throughout the ages: First, determine your position frequently. Second, use as many guides or landmarks as are available. ...

    Posted by on Monday, March 20, 2006 at 06:02 PM in Economics, Fed Speeches, International Finance, Monetary Policy | Permalink  TrackBack (0)  Comments (21)

          

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