Academic journal article Economic Review - Federal Reserve Bank of Kansas City

Longer-Term Perspectives on the Yield Curve and Monetary Policy

Academic journal article Economic Review - Federal Reserve Bank of Kansas City

Longer-Term Perspectives on the Yield Curve and Monetary Policy

Article excerpt

In the spring of 2004, there was widespread expectation in financial markets that the Federal Reserve would shortly begin the process of raising its federal funds rate target back toward a more normal level. At the time, there was considerable concern that removing policy accommodation could lead to a sharp rise in long-term interest rates that might roil financial markets or slow the economic recovery. Much of this concern was based on the sizable increases in long-term rates that occurred when the Federal Reserve tightened policy in 1994-95 and 1999-2000.

In contrast to the conventional wisdom, however, longer-term rates actually declined as the funds rate target rose. Indeed, in August 2005, after the Federal Reserve had raised its federal funds rate target from 1 percent to 3½ percent, the yield on the benchmark 10-year Treasury note remained below its level at the onset of policy tightening. This surprising behavior of long-term rates has been labeled a "conundrum" by Federal Reserve Chairman Greenspan and many financial market participants, and considerable effort has been made to understand the causes of the conundrum and its implications for monetary policy.

This article provides a framework for understanding the relationship between monetary policy and the yield curve that can be used to analyze the behavior of long-term rates during periods of monetary policy tightening. This framework is used to examine two recent episodes of policy tightening, in 1999-2000 and 2004-05. The analysis reveals that the conundrum period is highly unusual, but it also suggests that the relationship between monetary policy and the yield curve is quite complex and highly variable over time.

The first section of the article compares the relationship between the yield curve and monetary policy across nine episodes of monetary policy tightening over the past 40 years, highlighting patterns in this relationship that are common to all nine episodes. The second section provides an analytical framework that helps identify economic factors behind each of these patterns. The third section uses this framework to analyze the behavior of the yield curve in the two most recent episodes of monetary policy tightening. The final section summarizes the analysis and discusses its broader implications for understanding the relationship between the yield curve and monetary policy.

I. HISTORICAL PERSPECTIVE ON YIELD CURVES AND MONETARY POLICY

A brief survey of historical episodes of monetary policy tightening supports the view that the recent behavior of long-term interest rates is unusual but also reveals that the relationship between interest rates and monetary policy is quite complex and changes over time. A closer look at the historical evidence highlights three distinct patterns in this relationship and suggests the possibility of identifying a common set of economic factors that can be used to explain historical differences in yield curve behavior.

What happens to long-term rates when policy is tightened?

To begin, it is useful to place the recent behavior of long-term rates in historical context. The nature of a conundrum is that it is both unusual and difficult to explain. How unusual is it for long-term interest rates to fall when monetary policy is being tightened? One approach is to see what happened to long-term rates in past periods of policy tightening. Chart 1 shows the response of long-term rates during the first stage of policy tightening in the current cycle as compared with eight previous periods of policy tightening over the past four decades. The response of long-term rates is measured as the change in the yield on the 10-year Treasury note during the first 100-basis-point increase in the federal funds rate.1

In the current episode, the 10-year Treasury rate fell from 4.94 percent in May 2004 to 4.36 percent in November 2004 as the federal funds rate target was increased from 1 percent to 2 percent. …

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