Fact-Checking Bernanke's Yield Curve Comments
I am not going to summarize Bernanke's remarks to the Economic Club of New York of last night entitled "Reflections on the Yield Curve and Monetary Policy." The speech was relatively short and easy to understand, so you can read it for yourself at this url: http://www.federalreserve.gov/BoardDocs/speeches/2006/20060320/default.htm. What I am going to do is a little fact checking related to some of his comments.
"I have argued elsewhere that improved monetary policies, which stabilized inflation and better anchored inflation expectations, are an important reason for this positive development; no doubt, structural changes in the economy such as deregulation, improved inventory control methods, and better risk-sharing in financial markets also contributed. Whatever the reason for the fall in macroeconomic volatility, if investors have come to expect this past performance to continue, they might believe that less compensation for risk--and thus a lower term premium--is required to justify holding longer-term bonds. In that regard, it is interesting to observe that long-term forward rates were also low in the 1950s and 1960s. With long-term inflation expectations apparently anchored at low levels and with the prospect of continued economic stability, market participants may believe that it is appropriate to price bonds for an environment like that which prevailed four or five decades ago." [emphasis added]
"I would not interpret the currently very flat yield curve as indicating a significant economic slowdown to come, for several reasons. First, in previous episodes when an inverted yield curve was followed by recession, the level of interest rates was quite high, consistent with considerable financial restraint. This time, both short- and long-term interest rates--in nominal and real terms--are relatively low by historical standards. Second, as I have already discussed, to the extent that the flattening or inversion of the yield curve is the result of a smaller term premium, the implications for future economic activity are positive rather than negative." [emphasis added]
So, there you have it. The low level of term premia in the bond market today is reminiscent of the 1950s and 1960s. And, the flattening in the yield curve today has been accompanied by low nominal and real interest rates. So, from this, can we then assume that the behavior of the yield curve in the 1950s and 1960s was not a good leading indicator of economic activity? Let's see. Chart 1 shows that both the August 1957 - April 1958 and April 1960 - February 1961 recessions were preceded by a narrowing but not an inversion in the yield spread between the Treasury 10-year security and fed funds. So, back in the 1950s and 1960s, when term premia were low, a yield curve inversion was not necessary to signal a recession - just a flattening was sufficient. So, perhaps Bernanke should not be so quick to say that the macroeconomic implications of the recent flattening of the yield curve is different this time.
Also note in Chart 1 the level of the CPI-inflation-adjusted fed funds rate as the yield curve flattened prior to the 1957 and 1960 recessions. In August 1957, the peak of that economic expansion, the "real" fed funds rate level was minus 0.42% (nominal level was 3.24%). In April 1960, the peak of that expansion, the level of the real fed funds rate was 2.20% (nominal level was 3.92%). So, both the real and nominal levels of the fed funds rate were relatively low as the yield curve flattened and the economy went into a recessions in 1957 and 1960. Again, why is it different this time?
"Finally, the yield curve is only one of the financial indicators that researchers have found useful in predicting swings in economic activity. Other indicators that have had empirical success in the past, including corporate risk spreads, would seem to be consistent with continuing solid economic growth." [emphasis added]
If by "corporate risk spreads," Bernanke is referring to corporate bond credit yield spreads, then he's looking at a lagging or coincident, at best, economic indicator, not a leading one. Chart 2 shows that credit spreads tend to widen out after a recession has been entered. Moreover, the highest absolute-value correlation between the Treasury 10-year - fed funds spread and corporate bond credit spread occurs when the 10-year - fed funds spread is advanced by six quarters. To say that the flattening in the yield curve is The opinions expressed herein are those of the author and do not necessarily represent the views of The Northern Trust Company. The Northern Trust Company does not warrant the accuracy or completeness of information contained herein, such information is subject to change and is not intended to influence your investment decisions. not signaling an economic slowdown because credit spreads are still narrow (actually, they have widened out somewhat) is akin to driving forward while looking in the rearview mirror.
Lastly, Bernanke lived up to the rap put on most economists - on the one hand, on the other hand. After devoting a lot of words to why the implications of the flat yield curve might be different this time, he opens the escape hatch. But he doesn't even get this one right.
"An alternative perspective holds that the recent behavior of interest rates does not presage an economic slowdown but suggests instead that the level of real interest rates consistent with full employment in the long run--the natural interest rate, if you will--has declined." [emphasis added]
"About a year ago, I offered the thesis that a "global saving glut"--an excess, at historically normal real interest rates, of desired global saving over desired global investment--was contributing to the decline in interest rates ... So long as these factors persist, global equilibrium interest rates (and, consequently, the neutral policy rate) will be lower than they otherwise would be."
The "escape hatch" part of this is that perhaps the relatively low structure of interest rates is not a sign of easy financial conditions. But if this is so, then the flat yield curve is sending the message that slower economic growth lies ahead.
The headlines in the financial press seemed to reflect at which part of the Bernanke speech the headline writer was awake during the speech. The headline in the FT was "Bernanke sees no sign of slowdown." The writer was awake at the beginning then dozed off. The teaser on the front page of the WSJ was "Bernanke said the Fed should keep short-term rates lower than normal if a glut of world saving is keeping long-term rates low." The writer was napping early on, and then someone nudged him at the end.