The guest commentary was written by Dr. Daniel Thornton of D.L. Thornton Economics.
I had a call from a reader who noted that the spread between 10-year and 2-year Treasury rates had narrowed considerably recently and wondered whether I had any idea why this occurred. I said yes, I know why it occurred. It occurred for the same reason Greenspan’s famous conundrum occurred.
Specifically, the marked narrowing of the 10yr/2yr spread occurred because the FOMC is implementing monetary policy by targeting interest rates and it increased its target by 1 percentage point over the last year. I show that this also caused longer-term rate spreads to narrow as well. Interest rates are important for the allocation of credit. Hence, I argue targeting interest rates is bad unless one believes the Federal Open Market Committee (FOMC) can allocate credit better than the market. I suggest the Fed’s historical track record provide s little confidence that it can. Rather than have Congress require the Fed to adopt a specific interest rate rule, as a number of prominent economists have suggested, I recommend Congress order the Fed to stop targeting interest rates. I end the essay suggesting the economics profession needs to engage in an open debate about the validity of the theory upon which various strategies for implementing monetary policies are based and the evidence (facts) that support claims of their effectiveness.
For those of you who may not know or remember Greenspan’s conundrum, at his February 2005 congressional testimony, Greenspan noted that the 10-year Treasury rate declined slightly in spite of the fact that the FOMC had increased its target for the federal funds rate by 150 basis points. He considered several possible reasons for this anomaly. Rejecting all of them, he called it a “conundrum.” The conundrum got worse. The FOMC increased the funds rate target another 275 basis points by late June 2006 and the 10-year Treasury rate remained essentially unchanged. In research that is forthcoming in the Journal of Money, Credit, and Banking (here), I explain why Greenspan’s conundrum—the break in the relationship between the federal funds rate and the 10-year Treasury rates—occurred.
First, I show that the relationship between the funds rate and the 10-year Treasury rate changed long before Greenspan noticed it. It changed in the late 1980s, with the most likely date being May 1988. The historical positive correlation between changes in the 10-year Treasury rate and changes in the federal funds rate vanished after the late 1980s and never returned. I go on to show that this happened because the FOMC began targeting the federal funds rate to implement monetary policy. Before the change, all interest rates responded to the same information (aka, economic fundamentals: expectations for inflation, output growth, government policy, and a variety of other things, some of which are idiosyncratic to the particular rate). This accounts for the historical positive correlation between changes in the federal funds rate and changes in the 10-year Treasury rate. Indeed, it accounts for the fact that changes in essentially all rates were positively correlated. After the FOMC began targeting the federal funds rate, it changed only when the FOMC changed its funds rate target. Since the FOMC did not respond to economic fundamentals in the same way as the 10-year Treasury rate, the correlation between the rates vanish.
Because the FOMC was now determining the federal funds rate, other rates began responding to it as well. There were now two forces affecting interest rates along the term structure; economic fundamentals and the FOMC’s target for the federal funds rate. Long-term rates that are most closely linked to economic fundamentals continued to be determined by economic fundamentals as before, but other rates were increasingly affected by the FOMC’s funds rate target. I showed that the effect of the federal funds rate on other rates was particularly strong when the FOMC set the target at a level that was at odds with the level consistentwith economic fundamentals, i.e., with the behavior of long-term rates. The effect is particularly strong if the FOMC maintains the target at a level that’s inconsistent with economic fundamentals for a long period. Indeed, my forthcoming paper shows that when the FOMC reduced the target to the then historically low level of 1.0 percent and kept it there for a year, the spread between the 10-year rate and Treasury rates from 3-months to 5 years widened significantly.
The FOMC’s interest-rate-targeting accounts for the narrowing of the spread between the 10-year and 2-year Treasury rates. The FOMC began increasing its target aggressively at its December 14, 2016, FOMC meeting. Specifically, the FOMC increased the IOER (the interest rate it pays banks to hold excess reserves) from 50 basis points to 150 basis points from the December 2016 meeting to the December 2017 meeting. Consequently, the 2-year Treasury rate increased relative to the 10-year rate causing the 10yr/2yr spread, shown in the figure below, to narrow by 74 basis points. The figure shows that the FOMC’s actions caused other Treasury rate spreads to narrow as well. Consist with my forthcoming research, the magnitude of the effect gets smaller as the maturity of the bond increases. Consistent with what I showed in a previous essay (here), the FOMC’s interest rate targeting even affected the 10-year Treasury rate: The figure shows that the 20yr/10yr spread declined by 16 basis points, from 32 basis points to 16 basis points. The effect is small, but it’s not zero.
The federal funds rate and the IOER, per se, have no important economic function and would have essentially no effect on the economy were it not for the fact that the Fed is setting the rate. Hence, it’s important to understand why the Fed’s setting of these interest rates has such a large effect on interest rates across the term structure.
The effect of the FOMCs interest rate target is large for the same reason a wide variety of interest rates were tied to the LIBOR and why the funds rate stays close to the FOMC’s federal fund rate target, see Rain Man. I encourage you to read the “Rain Man” essay, but the answer to both questions is the same; credit is very difficult to price. Unlike TVs, furniture and other physical goods whose costs of production are significant and determine a price floor, the “production” costs of credit are trivial; they provide no guidance for the interest rate to charge when making a loan. Consequently, many short-term rates were either directly tied to LIBOR rates or priced off of LIBOR. This is odd because LIBOR rates are not based on market transactions. They are the simple average of responses by banks to a survey of the rate they would charge other banks that day. There was a LIBOR scandal in 2008 when the Wall Street Journal reported that several large international banks reported unjustifiably low LIBOR rates.Indeed, lying on the survey got Tom Hayes, aka the “Rain Man,” sentenced to 14-years in the slammer.
The difficulty in pricing credit is the same reason the FOMC’s setting of the federal funds rate since the late 1980s and, more recently, the IOER, has had a strong effect on interest rates across the term structure. The Fed is the nation’s central bank. It is widely believed that Fed actions have a considerable effect on the economy and a wide range of asset prices. Many market participants believe that the Fed has superior insight into the behavior of the economy and financial markets. Hence, the FOMC’s setting of a target for an otherwise insignificant interest rate has consequences for market rates across the term structure. Because of their training, economists have difficulty believing that the effect is so strong. I would too, if the evidence wasn’t so strong.
“Is it good or bad that the FOMC’s setting of these rates has such a large effect on other interest rates?” Interest rates are critical for the allocation of credit. So if one believes that the FOMC knows more about how credit should be allocated than the market, it’s good. When the Fed initiated its large-scale assets purchase program, known as quantitative easing (QE), a number of FOMC participants (nearly all of whom were Federal Reserve Bank Presidents) were concerned about purchasing anything other than government securities. They were concerned that purchasing mortgage-backed securities and other non-Treasury securities would interfere with the allocation of credit, (see Requiem for QE, pp. 7-8 for details).
Indeed, with the exception of its short-lived and failed “operation twist” policy in the early 1960s, the Fed has had a policy of minimizing the effect of open market operations on the allocation of credit. Consequently, prior to its QE policy, it only purchased very shortterm Treasuries. Because interest rates are critical for the allocation of credit, they are also important for the allocation of economic resources. The greater the effect of the FOMC’s interest rate policy on rates across the term structure, the greater the effect on the allocation of credit and economic resources. Those opposed to purchasing non-Treasury securities because of the effect on the allocation of credit should be just as concerned about the effect of the FOMC’s interest rate policy on interest rates across the term structure. Personally, I believe it is not only a bad thing, it’s dangerous.
If you are inclined to think it is a good thing or at least not a really bad thing, you might want to consider the fact that the Fed’s record is not stellar. Milton Friedman and Anna Schwartz made a compelling case that the Fed’s actions following the October 1929 stock market crash intensified and prolonged the Great Depression. A compelling case is made that bad monetary policy caused the Great Inflation of the 1970s and early 1980s and that the corrective measures that Paul Volcker’s Fed was forced to take caused severe back-to-back recessions in the early 1980s. While the Fed did not directly cause the house-price bubble and subprime lending that resulted in the financial crisis, John Taylor makes a good case that the excessively low interest-rate policy the FOMC maintained from about 2000 through 2005 contributed to it.
The Fed also turned a blind eye to subprime lending. In What the Fed Did and What It Should Have Done, I argued the Fed errored in “sterilizing” the effect of its lending to banks and financial institutions before Lehman Bros.’ bankruptcy on September 15, 2008, and errored in adopting its QE policy after Lehman’s failure. Finally, I show (here) and in several other essays that the Fed’s large balance sheet has produced a massive increase in total checkable deposits and, hence, the M1 money measure. The massive amount of liquidity this policy created could have severe implications for future inflation.
Finally, it is likely that some perhaps many economists and policymakers might be saying, “You’ve shown that the FOMC can affect long-term rates by controlling the funds rate. This means that monetary policy is effective because long-term rates are more important for spending decisions.” I might agree except for the facts that; (1) spending is not very interest sensitive—it takes a large change in long-term rates to have a significant effect on spending, and (2) my forthcoming research shows that the FOMC has to move the funds rate far away from the level that is consistent with economic fundamentals to have much of an effect on interest rates that are likely to matter most for spending.
A large number of economists believe Congress should require the Fed to adopt a specific interest rate rule to implement policy. I disagree. Indeed, I believe Congress should order the Fed to stop targeting interest rates. The Fed won’t do this on its own if for no other reason than it doesn’t know what else to do. The economics profession should address this problem by engaging in an open debate about just how monetary policy works and its effectiveness. The debate should focus on the validity of the theory upon which various strategies for implementing monetary policies are based and the evidence (facts) that support claims of their effectiveness.
EDITOR'S NOTE
This is a Hedgeye Guest Contributor piece written by Dr. Daniel Thornton. During his 33-year career at the St. Louis Fed, Thornton served as vice president and economic advisor. He currently runs D.L. Thornton Economics, an economic research consultancy. This piece does not necessarily reflect the opinion of Hedgeye.
