Academic journal article ABA Banking Journal

A Rate Cut, If It Comes, Will Be Short-Lived

Academic journal article ABA Banking Journal

A Rate Cut, If It Comes, Will Be Short-Lived

Article excerpt

Ram Bhagavatula, Chief Financial Economist, Citibank, and a member of the ABA Economic Advisory Committee.

In recent months, there's been a ground swell of opinion in favor of an immediate easing of the Federal Reserve's monetary policy because of global market turmoil and falling inflation, mostly in the prices of commodities. The persistent decline in Treasury yields since May has steepened since the Russian turmoil broke in August. The entire Treasury yield curve is now below the Fed funds rate target. This is seen as heralding the need for a Fed easing. Though past business cycle experience might make this an obvious policy response, there are enough differences in the present episode to suggest otherwise.

The most important difference now is the stance of Fed policy in the months preceding the recent slump in Treasury yields. In past business cycles, the spread between the funds rate target and market yields widened because inflation concerns drove the Fed to hike the funds rate target aggressively. Then, at some point, market yields began to lag on the upward move as expectations of an economic slowdown took hold. Finally, the onset of a recession forced the Fed to ease policy.

This time around, Treasury yields have fallen for an entirely different reason. The Fed has kept the funds rate target more or less steady since early 1996. The big drop in Treasury yields has occurred in response to a flight to quality among global investors in the face of a sequence of problems that began in east Asia in October 1997. These problems were followed by the recognition of a recession in Japan in spring 1998 and, most recently, by the Russian crisis. As the unpleasant surprises piled up, risk aversion among investors has suddenly intensified and the demand for risk-free assets has ballooned. These assets mostly include industrial country government debt. So, not only have U.S. Treasury yields fallen, but also the yields on German, Japanese, and British government securities. …

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