Academic journal article Chicago Fed Letter

Macroeconomic Sources of Recent Interest Rate Fluctuations

Academic journal article Chicago Fed Letter

Macroeconomic Sources of Recent Interest Rate Fluctuations

Article excerpt

The authors use a new statistical method to attribute daily changes in U.S. Treasury yields and inflation compensation to changes in investor beliefs about domestic and foreign growth, inflation, and monetary policy. They find that while foreign developments have been important drivers of U.S. yields and expected inflation over the last decade, the recent divergence between U.S. and European monetary policy has had little effect. Instead, the behavior of asset prices seems consistent with positive "aggregate supply shocks." One candidate for such shocks is the large decline in energy prices experienced since June 2014.

Between mid-2014 and late 2015, U.S. labor market conditions continued to improve, and Federal Open Market Committee (FOMC) communications increasingly pointed to a first interest rate hike in almost a decade, which occurred in December. We would have expected these developments to be associated with a rise in longer-term Treasury yields, as often observed prior to past episodes of monetary policy tightening. Expectations for inflation also usually increase prior to policy tightening, as the strengthening economy leads market participants to anticipate rising prices.

In stark contrast to this typical pattern, however, nominal U.S. Treasury yields declined slightly over this period, and a proxy for expected inflation given by the spread between nominal yields and those on Treasury inflation-protected securities (TIPS), also known as inflation compensation, decreased significantly. In this Chicago Fed Letter, we use new empirical methods based on comparisons of daily relative movements in asset prices to explain this seemingly anomalous behavior.

One possible explanation for the puzzling movement in Treasury yields and inflation compensation that has received some attention is that slowing global economic growth and disinflationary pressures abroad may have spilled over into U.S. markets over this period. For example, over the last several years European developments have frequently figured prominently in the financial news, and, unlike the Fed, the European Central Bank (ECB) has aggressively eased policy in recent months. Our analysis is broadly consistent with these observations: We find that global shocks were important drivers of U.S. yields and expected inflation over the last decade, but they appeared to be less important during the run-up to the FOMC's recent rate increase.

Instead, we find that between June 2014 and December 2015, market participants' expected U.S. growth trended higher while expected U.S. inflation trended lower. These two phenomena had offsetting effects on longer-term U.S. interest rates. This combination of stronger growth and weaker inflation sounds very much like a classic "aggregate supply shock," i.e., an event that causes output and prices to move in opposite directions. A natural candidate for such a shock is the large decrease in oil prices that began in the second quarter of 2014.

Recent trends in U.S. and European yields

The blue and red lines in figure 1 show daily movements in the ten-year nominal U.S. Treasury yield and ten-year TIPS inflation compensation from June 2005 to December 2015.2 The large net declines in both yields and inflation compensation during the recent financial crisis are consistent with the weaker growth, aggressive policy easing, and declining energy prices that buffeted the U.S. economy in 2008 and 2009. Between early 2010 and mid-2014, yields drifted down further, amid continued easing by the Federal Reserve, while inflation compensation fluctuated within a 100-basis-point range. Between mid-2014 and December 2015, yields and inflation compensation have come down further, despite fairly steady data on economic growth and core inflation and the approach of the first rate hike in almost ten years. This seems particularly odd since, even before the actual rate increase, survey evidence shows that market participants believed that the FOMC would act to increase short-term interest rates in the relatively near future. …

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