Decomposing the Yield Curve Spread

Just last week I had a post titled "The Interest Rate Conundrum that Wasn't" where I discussed how many observers misread the flattening and then the inverting of the yield curve over the 2005-2007 period. As I noted then, the popular story was that the term premium was falling and thus there was nothing to fear from the changes in the yield curve. As we all now know, this interpretation was incorrect: the yield curve was telling us that a recession was in the making after all. Well today, Zubin Jelveh directs us to a similar posting he made back in January titled "That Trusty Yield Curve". The entire post is worth reading, but one part in particular I want to mention here. Zubin notes a study by Joshua Rosenberg and Samuel Maurer that decomposes the yield curve spread into its (1) interest rate expectations and (2) term premium components. What they find can be seen in the following figure where the gray columns denote recessions: (click on figure to enlarge.)

This figure shows--and the authors demonstrate more formally with some statistical tests--that it is changes in the interest rate expectations component that predicts recessions, not changes in the term premium. The variation in the term premium is typically too small to matter, including during the "conundrum" period. This is interesting work.

Repeating the Fed's Policy Mistake of 1936-1937

Is the Federal Reserve (Fed) making a similar mistake to the one it made in 1936-1937? If you recall, the Fed during this time doubled the required reserve ratio under the mistaken belief that it would reign in what appeared to be an inordinate buildup of excess reserves. The Fed was concerned these funds could lead to excessive credit growth in the future and decided to act preemptively. What the Fed failed to consider was that the unusually large buildup of excess reserves was the result of banks insuring themselves against a replay of the 1930-1933 banking panics. So when the Fed increased the reserve requirements, the banks responded by cutting down on loans to maintain their precautionary level of excess reserves. As a result, the money multiplier dropped and the money supply growth stalled as seen in the figure below. (click on the figure to enlarge.)
This development, in conjunction with a contractionary fiscal policy, led to the recession of 1937-1938 and ultimately prolonged the Great Depression.

Now in 2008 the Fed did not suddenly increased reserve requirements, but it did just start paying interest on excess reserves. The Fed, then, just as it did in 1936-1937 has increased the incentive for banks to hold more excess reserves. As a result, there has been a similar decline in the money multiplier and the broader money supply (as measured by MZM) which I documented yesterday. If the Fed's goal is to stabilize the economy, then this policy move appears as counterproductive as was the reserve requirement increase in 1936-1937.

So why is the Fed paying interest rates on excess reserves? The answer from the Federal Reserve Board and other commentators is that this policy move makes the federal funds rate more manageable. Jim Hamilton gives a more compelling reason:

It's clear that the Fed is now also using yet another tool to balloon its balance sheet, namely, deliberately encouraging banks to sit on their excess reserve deposits. When these started to shoot up at the end of September, I initially attributed this to frictions in the interbank lending market. But with the announcement on October 6 that the Fed would begin to pay interest on those deposits, and the further announcement on October 22 that the Fed is now raising that interest rate to within 35 basis points of the target for the fed funds rate itself, it is clear that the Fed has now settled on a deliberate policy of encouraging banks to just sit on the reserves it creates, giving it another device with which to expand its balance sheet without increasing the quantity of cash held by the public.

Now the reason the Fed is ballooning its balance sheet is to be able to "buy" targeted assets from the troubled financial sector without actually increasing the overall money supply. The idea, as I understand it, is to restore confidence to financial markets--what Paul Krugman calls the "Face Slap Theory"--without actually creating any additional spending or inflationary pressures. Pardon me for being skeptical, but from what I can see this approach has only encouraged banks to hoard more excess reserves. I may be missing something here--and please let me know if I am--but it seems like we are making the same policy mistakes that were made in 1936-1937.

George Selgin Discusses Good Money

George Selgin has been highly influential in shaping my own thinking about monetary policy. My critique of U.S. monetary policy in the early-to-mid 2000s that has been a prominent part of this blog is based on Selgin's work on deflation. Selgin, though, has other research interests. This past summer he published a book called Good Money which I posted on here. Now you can listen to Selgin discuss his new book in this podcast interview. For more commentary on this book, see Alex Tabarrok's review of the book here.

Thinking About the Dollar

The U.S. may be heading into its worst recession in 40 years. Normally, such a development would result in a declining U.S. dollar. Instead, the dollar is strengthening as seen in the figure below which shows a weighted average of the dollar against its trading partners (click on figure to enlarge):

So what explains the rapid appreciation of the dollar? Bloomberg says the following:

Oct. 25 (Bloomberg) -- The dollar gained the most in 16 years against the currencies of six major U.S. trading partners as a global economic slowdown spurred demand for the greenback as a haven from losses in emerging markets.

``The foreign-exchange market is basically saying we are in a global recession and perhaps a very, very deep one,'' Richard Franulovich, a senior currency strategist at Westpac Banking Corp. in New York, said in an interview on Bloomberg Radio.

[...]

``We are in a financial crisis,'' said Richard Clarida, a global strategist at Newport Beach, California-based Pacific Investment Management Co., which oversees $830 billion in assets, including the world's biggest bond fund. ``The flight to quality is boosting the dollar and the yen.''

Emerging-market currencies tumbled as Argentina seized private pension funds, and Belarus, Ukraine, Hungary and Iceland joined Pakistan in requesting at least $20 billion of emergency loans from the International Monetary Fund. Brazil's real dropped 8.2 percent to 2.3075 against the dollar, the South African rand decreased 10.4 percent to 11.18 and the Russian ruble fell 3.2 percent to 27.1991.

So a negative economic shock that originated in the United States--the downturn in the U.S. housing market--has set off a global recession that is causing a flight to the dollar and is thus increasing its value. If this understanding is correct, then I have failed to appreciate the full extent of the exorbitant privilege the United States gets from having the main reserve currency of the world.

Update: Mark Thoma directs us to Paul Krugman, Dani Rodrik, Edward Harrison, and Simon Johnson for discussion on the stresses in emerging markets from the declines in their currencies.

This Picture (Almost) Says it All

Dani Rodrik recently showed us the financial crisis in one picture. Well here is the financial crisis in one cartoon, complements of Slate. I only wish the cartoon had depicted the low interest environment in the early-to-mid 2000s under one of seven deadly sins. (Click on the figure to enlarge):

The Interest Rate Conundrum That Wasn't

Thanks to the prompting of ECB, I was reminded of the interest rate "conundrum" of 2005-2006. The "conundrum" at this time was that long-term interest rates refused to follow short-term interest rates up as the Fed tightened monetary policy. Based on the expectations theory of interest rates--which says long-term interest rates are the average of expected future short term interest rates plus a risk premium--there were two obvious interpretations for this development: (1) the risk premium had fallen or (2) the economy was headed for a recession. Despite the inordinate run up in leverage and house prices at the time--signs that U.S. economic expansion was not sustainable--many observers chose to believe some variant of (1). For example, one very prominent Fed official said the following in 2006:

Although macroeconomic forecasting is fraught with hazards, 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, consistent with considerable financial restraint. This time, both short- and long-term interest rates--in nominal and real terms--are relatively low by historical standards.Second, as I have already discussed, 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.

Other reasons given around this time for not viewing the inverting of the yield curve as pointing to a recessions were that (1) other financial indicators such as the rise in stock prices indicated solid economic growth ahead and (2) the conundrum was a global phenomenon, not just a U.S. one. We now know the inverting of the yield curve was not a "conundrum", but simply a sign of the recession to come. The term premium and other financial indicators pointing up interpretations were off the mark in this case, while the global scope of inverting yield curves meant a global recession was in store.

The figure below--which shows the 10 year-3 year treasury yield curve spread, the NBER-dated recessions, and the recession that presumably started in 2007:Q4--indicates that during the time of the "conundrum" the yield curve spread was simply doing what it does best: predicting a recession. (Click on figure to Enlarge.)


Although many observers somehow missed this straightforward interpretation of the inverting yield curve, others got it right. For example, Calculated Risk wrote in 2005 the following:

I think the PRIMARY reason for Greenspan's conundrum is that the economy is weaker than it appears. Using GDP growth and unemployment, the US economy is healthy. But the level of debt (both consumer and government), the real estate "boom" that seems based on leverage and loose credit (see Volcker's recent comments), and the poor employment situation (especially the low level of participation) indicate an unhealthy economy. I believe this recovery is being built on a marshland of debt and the bond market is reflecting this weakness.

For some observers, then, there was no "conundrum". The inverting yield curve was simply a sign of future economic weakness. How prescient they now look.

The Monetary Policy - Long Term Interest Rate Link

Tyler Cowen argues that the Fed's low interest rate policy in the early-to-mid 2000s may have been a contributing factor, but certainly was not the most important one leading to the financial crisis. In making his case, Tyler says the following:

[O]ther reasons also suggest that monetary policy was not the main driver. Money has a much bigger effect on short-term rates than long-term rates.

I am not sure what Tyler exactly means by "bigger", but I do know there has been a spate of empirical studies showing monetary policy affects long-term rates in a non-trivial manner. Richard Froyen and Hakan Berument (F&B) provide a good survey of this literature in their forthcoming paper, "Monetary policy and U.S. long-term interest rates: How close are the linkages?" From their introduction is the following:

[T]he effect of monetary policy on long-term interest rates is a subject of considerable interest. Given current U.S. monetary policy procedures, this question reduces to that of how a change in the federal funds rate affects the yields on longer-term securities. A decade ago a reading of theliterature would have indicated considerable doubt about even the direction of this effect. There was also a view that the size and persistence of the effect of the federal funds rate on longerterm yields would vary with economic conditions. The prevailing theory of the term-structure of interest rates, the expectations hypothesis, by itself provides little guidance about the effect monetary policy actions will have on longer-term interest rates: the nature of the effect depends on the way in which the policy action affects expected future short-term interest rates and risk premiums imbedded in long rates.

Research since 2000 has changed the situation. Studies by Kuttner (2001), Cochrane and Piazzesi (2002), Gurkaynak, Sack, and Swanson (2005a), Ellingsen and Soderstrom (2003), Ellingsen, Soderstrom, and Masseng (2004) and Beechey (2007) provide evidence that unanticipated changes in the federal funds rate have significant effects on U.S. interest rates at maturities as long as 10 or 30 years. Kuttner’s estimates, for example, indicate that an unanticipated rise ofone-percentage point in the federal funds target rate will increase the interest rate on a 10-year government security by 32 basis points and the rate on a 30-year security by almost 20 basis points.

(F&B also note that though some research based on vector autoregressions (VAR) show results more consistent with Tyler's view, these studies ultimately are flawed.) Now if we make the reasonable assumption that the drop of the fed funds rate (ffr) all the way to 1% for a sustained period was unexpected by several percentage points--the ffr has not been dropped that low since the 1950s--and adopt Kuttner's magnitudes then it is easy to imagine the Fed having a significant influence on long term interest rates during the early-to-mid 2000s.

One could also argue that some of the "global saving glut" and its influence on long-term interest rates was simply an amplification of the Fed's easy monetary policy via the dollar block countries' central banks. But I digress. The key point here is that there is evidence monetary policy still matters in a meaningful way for long-term interest rates.