Wednesday, October 22, 2008

The Interest Rate Conundrum That Wasn't

Thanks to the prompting of ECB, I was reminded of the interest rate "conundrum" of 2005-2006. The "conundrum" at this time was that long-term interest rates refused to follow short-term interest rates up as the Fed tightened monetary policy. Based on the expectations theory of interest rates--which says long-term interest rates are the average of expected future short term interest rates plus a risk premium--there were two obvious interpretations for this development: (1) the risk premium had fallen or (2) the economy was headed for a recession. Despite the inordinate run up in leverage and house prices at the time--signs that U.S. economic expansion was not sustainable--many observers chose to believe some variant of (1). For example, one very prominent Fed official said the following in 2006:
Although macroeconomic forecasting is fraught with hazards, 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.
Other reasons given around this time for not viewing the inverting of the yield curve as pointing to a recessions were that (1) other financial indicators such as the rise in stock prices indicated solid economic growth ahead and (2) the conundrum was a global phenomenon, not just a U.S. one. We now know the inverting of the yield curve was not a "conundrum", but simply a sign of the recession to come. The term premium and other financial indicators pointing up interpretations were off the mark in this case, while the global scope of inverting yield curves meant a global recession was in store.

The figure below--which shows the 10 year-3 year treasury yield curve spread, the NBER-dated recessions, and the recession that presumably started in 2007:Q4--indicates that during the time of the "conundrum" the yield curve spread was simply doing what it does best: predicting a recession. (Click on figure to Enlarge.)

Although many observers somehow missed this straightforward interpretation of the inverting yield curve, others got it right. For example, Calculated Risk wrote in 2005 the following:
I think the PRIMARY reason for Greenspan's conundrum is that the economy is weaker than it appears. Using GDP growth and unemployment, the US economy is healthy. But the level of debt (both consumer and government), the real estate "boom" that seems based on leverage and loose credit (see Volcker's recent comments), and the poor employment situation (especially the low level of participation) indicate an unhealthy economy. I believe this recovery is being built on a marshland of debt and the bond market is reflecting this weakness.
For some observers, then, there was no "conundrum". The inverting yield curve was simply a sign of future economic weakness. How prescient they now look.


  1. Yes, the amount of poor analysis coming out of the Federal Reserve - repository of supposedly our brightest and best - is quite disturbing (the latest Chari/Kehoe offering being a case in point).
    While on yield curves, how about an update from your recession probit model that you mentioned in your Valentine Day post ?

  2. As an update to your consistent theme about Federal Reserve culpability in the current crisis, I note Dean Baker had this to say in his blog:

    In fact, the problem is not that "we" cannot see events that far in advance. The problem is that the Federal Reserve Board and the economics profession as a whole functions more like a fraternity than a real forum for debate and truth seeking. Those whose views are taken seriously mimic the views of those with status and power within the profession, they do not think independently.

    The failure of the economics profession to recognize the bubble and the harm that it would cause was due to the sociology of the profession. For any competent economist, the bubble was easy to see and the damage that its collapse would cause was entirely predictable.