The Fed's Policy Can Be Effective with Low Long-Term Rates
April 13, 2015
Alan Greenspan called it a conundrum: the refusal of long-term interest rates to ratchet higher as the Federal Reserve raised the overnight benchmark rate from 1 percent in June 2004 to 5.25 percent June 2006. Ben Bernanke, Greenspan's successor as Fed chief, identified the cause: a global savings glut.
The yield curve inverted in mid-2006, and the outcome was entirely predictable: the recession. Policy makers always find a way to rationalize the unnatural state where short rates exceed long rates rather than rely on the indicators impeccable record of accomplishment.
While the Fed has yet to begin its effort to normalize interest rates, there is talk of a conundrum redux. Long-term yields have tumbled more than 100 basis points since the beginning of 2014 even as the U.S. economy strengthened. There is confusion over the implications.
New York Fed President Bill Dudley says the persistence of low long-term rates in the face of a rising benchmark rate would argue for "a more aggressive path of monetary policy normalization" because low bond yields create "a more accommodative set of financial market conditions." New York Fed also created a recession probability model based on the spread: the flatter or more inverted the curve, the greater the odds of recession.
The current probability of recession is quite low given the steep yield curve. However, the spontaneous decline in long rates over the past year, unmotivated by any change in policy, has some economists wondering about a possible inversion in response to a modest amount of Fed tightening.
Low long-term rates are not unique to the United States right now. The state of the economy, not the central bank, determines the real rate of return of investments, represented by an inflation-adjusted long-term rate.
If the constraints on the economy are such that the equilibrium long-term rate, or natural rate, is depressed, it will require only modest rate increases by the Fed when it comes time to apply the brakes.
Source: Caroline Baum, "No, Low Long-Term Rates Won't Counter Fed Actions," Economic Policies for the 21st Century, April 1, 2015.
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