- The Washington Times - Saturday, January 7, 2006

The vote by the Senate to confirm Ben Bernanke to succeed Alan Greenspan as chairman of the Federal Reserve Board is rapidly approaching. Mr. Bernanke’s hearings happen to coincide with widespread anticipation that the so-called “yield curve” will soon “invert,” a development that some economists fear could signal an economic slowdown or even a recession. We do not share those concerns.

A yield curve is a chart. It graphically portrays credit instruments of comparable quality but different maturity dates on the horizontal axis; on the vertical axis, it depicts their corresponding “yields” (i.e., interest rates). The most popular yield curve maps out the interest rates for U.S. Treasury bills (short-term credit instruments, e.g., three months); U.S. Treasury notes (medium-term, e.g., 10 years) and U.S. Treasury bonds (long-term, e.g., 30 years), all of which are backed by the full faith and credit of the U.S. government.

A normal Treasury yield curve is upward-sloping, showing that short-term rates are lower than longer-term rates. This normal occurrence arises from the fact that investors face greater uncertainty and risk when lending their money over longer-term horizons and thus demand greater compensation in the form of higher interest rates.

An inverted yield curve, which is the exception, reveals that short-term rates are higher than long-term rates.

Currently, the interest rate for the 90-day T-bill is about 4.2 percent, which reflects a tripling of that rate since the Fed began tightening monetary policy in late June 2004. Meanwhile, the current interest rate for the 10-year Treasury note is about 4.35 percent, which is actually lower than the 4.7 percent interest rate for 10-year notes that prevailed in late June 2004. (Mr. Greenspan’s famous “conundrum” related to the seemingly bewildering fact that the longer-term interest rate was barely budging over the past year and a half — indeed, it declined — while short-term rates were briskly rising.)

With 90-day money yielding 4.2 percent today and 10-year money yielding nearly the same, the Treasury yield curve is now virtually flat. By contrast, in June 2004, when the 90-day rate was 1.35 percent and the 10-year rate was 4.7 percent, the yield curve was steeply sloped in its normally upward direction. In the near future, it is widely expected that the 90-day yield will exceed the 10-year yield, thus inverting the yield curve.

Some economists are understandably concerned, since recessions followed five of the seven interest-rate inversions that have occurred since 1965.

When considering the effect of the changing shape of the Treasury yield curve, it is useful to keep in mind a few important points. First, the Fed can directly exert a significant amount of control over short-term interest rates. It does so by raising or lowering the federal funds rate. Through its open-market desk, which engages in the buying and selling of Treasury securities in the secondary market, the Fed controls the amount of excess reserves available throughout the banking system.

When the Fed wants to raise the fed-funds rate, it sells Treasury securities and drains excess reserves from the system. When the Fed wants to lower the fed-funds rate, it expands the amount of excess reserves in the banking system by buying Treasury securities. The interest rate for 90-day T-bills closely tracks the fed-funds rate for overnight loans. Thus, as the Fed raised the fed-funds rate from 1 percent in June 2004 to 4.25 percent today, the 90-day interest rate increased from 1.35 percent to 4.2 percent.

Second, the Fed has far less control over longer-term interest rates, which are largely determined by the international bond market, whose actions are especially affected by inflation expectations. The Fed’s indirect influence on longer-term rates is based upon whether the bond market views the Fed’s policy actions as contributing to rising-inflation expectations or declining-inflation expectations.

If the Fed’s actions are widely perceived (correctly or not) to be aimed at limiting inflation, the bond market will bid down the interest-rate premium related to inflation expectations; and longer-term rates will thus be lower than they otherwise would be.

The Fed has been very successful, so far, in convincing the bond market that its policy actions will contain inflationary pressures. Even as energy prices have soared, the Fed’s unrelenting policy of raising the fed-funds rate by a quarter-percentage point at each of its 13 meetings over the past 18 months has succeeded in preventing energy-price inflation from breaking out into other sectors.

As a result, inflation expectations have been contained, preventing any substantive increase in the inflation premium that partly comprises longer-term interest rates. To a significant extent, this probably explains why longer-term rates have remained relatively unchanged over the past 18 months. Another important factor has been the large supply of savings outside the United States that has been available for investing in longer-term U.S. Treasury securities, exerting downward pressure on their yields.

The third point to keep in mind about the consequences of an inverted yield curve is that when it comes to interest rates, size matters. In May 1981 — two months before the deepest post-World War II recession began — the 90-day T-bill rate averaged 16.3 percent. That was more than two percentage points above the May 1981 average interest rate for 10-year notes (14.1 percent). Not only had the yield curve inverted in a big way; but interest rates across the time spectrum were extremely high as well. Meanwhile, inflation expectations were very high, largely because consumer price inflation for 1979 and 1980 reached 11.3 percent and 13.5 percent, respectively. The Fed lacked credibility.

Today, if the yield curve inverts, it will do so at very modest levels of interest rates across the time horizon. Because the level of all interest rates will remain relatively low, Goldman Sachs believes an inverted yield curve at these levels will not cause a recession. We agree.

Moreover, the Fed’s credibility today is extremely high. With 90-day Treasuries likely to rise by another half-percentage point by March, matching the expected increase in the fed-funds rate, the yield curve may very well become inverted. Unlike in the past, however, the consequences should not be feared.

If you are looking for something to worry about, take your eye off the inverting yield curve and focus on the federal budget deficit, the soaring current-account (i.e., trade) deficit and the dismal personal savings rate, all of which are interconnected and simultaneously moving in the wrong direction.



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