Money and Financial Markets

Economic Trends, January 2003 | Go to article overview

Money and Financial Markets


As a tool of monetary policy, changing interest rates is only the means to an end. One (some would say the only) goal of monetary policy is low, steady inflation. How can we tell if monetary policy is on track for that a goal? One way is to look directly at money; after all, the textbook cause of inflation is "too much money chasing too few goods." If more money is created than the amount people are willing to hold, prices can rise. A simple model of money demand predicted future inflation effectively in the late 1990s but has done poorly since. The amount of money people are willing to hold varies considerably, which makes excess money a poor gauge of future inflation.

A different approach is to look to financial markets, which inherently entail consideration of the future. One gauge of markets' inflation expectations can be backed out by comparing yields on bonds that are protected against inflation with yields on nominal bonds that have no such protection. With this method, the yield spread between nominal 10-year Treasury bonds and 10-year, inflation-indexed securities provides a measure of inflation, even though differences in taxation and liquidity make the measure less pure than one would like. This gauge of inflation offers a reason for optimism: Expected inflation remains just above 1.5%. Equally important, inflation expectations have fallen since spring, even though the Federal Open Market Committee never raised rates in what is conventionally called "tightening."

Of course, one approach to expectations is simply to ask people, as in a survey, or to combine those survey results with financial market data. Although the results naturally will be sensitive to how the combining is done, this approach provides another cause for optimism: Inflation is in the range of 2% to 3%.

The FOMC sets only one shortterm interest rate directly, but financial markets produce a much richer set of rates. Since the beginning of 2002, yields on Treasury securities of all maturities have dropped substantially, creating a yield curve that has shifted downward. The curve remains steep, which historically has been a predictor of strong economic growth over the next four quarters.

Treasury bond rates have not been the only ones dropping. Rates on corporate bonds and conventional mortgages have also fallen over the year. Municipal bond rates, however, perhaps because of fiscal concerns in state and local governments, have held fairly steady, opening up a wide spread over 10-year Treasuries.

Spreads between risky and safe bonds give us a measure of the market's perception of risk--fears of a downturn, increased commercial failures, and the like. …

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