Thursday, March 5, 2020

The Decline of the 10-Year Treasury: Implications for Fed Policy

The 10-year treasury yield reached an historic low this week, crossing the 1% barrier. For many observers, this was a troubling development that confirms the U.S. economy is being sucked into the mire of secular stagnation. For others, it was an unsurprising outcome given the long-run trajectory of interest rates and the ongoing safe asset shortage problem.

Both views have some merit. The decline of the 10-year treasury yield does create problems for the U.S. economy, but it has been happening for some time. There is nothing magical about crossing the 1% barrier, though it does brings closer the day of reckoning for the Fed's operating framework.

The decline of the 10-year treasury yield, if sustained, means the entire yield curve may soon run into its effective lower bound. This will render useless much of the Fed's toolbox. Fortunately, there is a fix for the Fed's operating framework that makes it robust to any interest rate environment. This fix, ironically, ties the Fed more closely to fiscal policy while making it more Monetarist in practice. 

This post outlines the proposed fix, but first motivates it by explaining how the decline in the 10-year treasury yield creates problems for the U.S. economy.

Why The 10-Year Treasury Yield Decline Matters 
The are three reasons why the fall in the 10-year treasury yield matters. First, it implies there is an excess demand for safe assets. These are securities that are expected to maintain their value in a financial crisis and, as a result, are highly liquid. The biggest sources of safe assets are government bonds from advanced economies, especially U.S. Treasuries. The global demand for them has far outstripped their supply and this has led to the global safe asset shortage problem. The 10-year treasury yield falling below 1% is the latest manifestation of this phenomenon.

The safe asset shortage is problematic because it amounts to a broad money demand shock that slows down aggregate demand growth. One solution is for safe asset prices (interest rates) to adjust up (down) to the point that safe asset demand is satiated. The effective lower bound (ELB) on interest rates prevents this adjustment from happening and causes investors to search for safe assets elsewhere in the world. Other economies, as a result, are also affected by the safe asset shortage problem and experience lower aggregate demand growth.1

The demand for safe assets, as noted above, is closely tied to the demand for liquidity. This can be seen in the figure below which shows that the use of money assets (i.e. money velocity) closely tracks the 10-year treasury yield. Over the past decade, this has meant the public's desired money holdings have increased as the 10-year treasury yield has fallen. All else equal, this implies slower growth in aggregate spending.

Below is a chart from an upcoming policy brief of mine that illustrates this point from a global perspective. It shows the average 10-year government bond yield between 2009 and 2019 plotted against the average growth rate of domestic demand over the same period. The government bond yield can be viewed as the safe asset interest rate in these advanced economies. The figure reveals a strong positive relationship between the safe asset yield and the domestic demand growth rate.

One has to be careful interpreting the causality here, but I do further analysis in the policy brief and find shocks to the bond yields do influence domestic demand growth. The safe asset shortage, therefore, appears to be a drag on global aggregate demand growth. The first reason, then, why the decline in the 10-year treasury yield matters is that it portends weaker aggregate demand growth. 

The second reason the decline matters is that it leads to a flattening of the yield curve. Financial firms that fund short term and invest long term rely heavily on a positive slopping yield curve to make this business model work. A flattening yield curve undermines it and may lead to less financial intermediation. This is one reason an inverted yield helps predict recessions. In this case, however, the  effect may be longer lasting than the business cycle as the decline in treasury yields appears to be on a sustained path.

The third reason the decline matters is that it impairs the Fed's current tool box. The Fed's target interest rate is now down to a 1-1.25% range, a small margin for a central bank that normally cuts around 5% during a recession. The Fed could turn to large scale asset purchases once it hits the ELB, but with the 10-year treasury now near 1%, there is not much space here either. Consequently, the Fed's toolbox is shrinking and soon could be rendered useless. 

Now the Fed can add to its toolbox and indeed the Fed is exploring new tools--such as negative interest rates and yield curve control--under its big review of monetary policy. Even these tools, however, are limited since the declining 10-year treasury yield is compressing the yield curve

The Fed's current toolbox, in short, is premised on a positive interest rate world that is slowing fading. The Fed, therefore, may soon face a day of reckoning for its current operating framework. That possibility and what the Fed could do in response is considered next.

Revamping the Fed's Operating Framework
The Fed’s operating framework--defined here as the instruments, tools, and targets the Fed uses in its conduct of monetary policy--has been geared toward a positive interest rate environment. This framework has been increasingly strained by the downward march of interest rates. The 10-year treasury yield dropping below 1% underscores this challenge.

The Fed needs, consequently, an operating framework that is robust to any interest rate environment and one that is capable of stabilizing aggregate demand growth. I have proposed a fix to the Fed's operating system that addresses these challenges in a forthcoming journal article. Here I want to briefly outline that proposal. It has three parts: (1) the Fed adopts a dual reaction function, (2) the Fed adopts a NGDP level target, and (3) the Fed is empowered with a standing fiscal facility for use at the ZLB.  The three parts are explained below. 

Part I: A Dual Reaction Function. To make the Fed’s operating framework robust to both positive and negative interest rate environments, I call for a two-rule approach to monetary policy. Specifically, the Fed would follow a version of the Taylor rule when interest rate are above zero percent and follow the McCallum rule when interest rate are at zero percent or below. The former rule uses an interest rate as the instrument of monetary policy while the latter rule uses the monetary base as the instrument.  Consequently, the Fed would have effective instruments to use no matter what happens to interest rates. 

Part II: A NGDP Level Target. A level target provides powerful forward guidance since it forces the central bank to make up for past misses in its target. For reasons laid out here, I prefer a nominal NGDP level target (NGDPLT) and specifically, one that targets the forecast. This combined with the first feature implies the following dual reaction function system for the Fed:

Here, in is the neutral interest rate, the NGDPGap is the percent difference between the forecasted level of NGDP and the NGDPLT for the period of t to t+hΔb is the growth rate of the monetary base, Δx* is the target NGDP growth rate, and Δv is the expected growth rate in the velocity of the monetary base for the period of t to t+h.

Part III: A Standing Fiscal Facility. The final part of the proposal establishes a standing fiscal facility for the Federal Reserve to use when implementing the McCallum rule. That is, when the Fed starts adjusting the the growth of the monetary base according to the McCallum rule, it will do so by sending money directly to the public. My proposal, then, incorporates 'helicopter drops' into the Fed's toolkit in rule-like manner. 

I provide more details in the paper, but here are the advantages of this proposed operating framework. First, it keeps countercyclical macroeconomic policy at the Federal Reserve. This provides continuity with the existing division of labor between the U.S. Treasury Department and the Federal Reserve.  Second, it enables the Fed to provide meaningful countercyclical monetary policy no matter what happens to interest rates. Third, it provides credible forward guidance since it combines a NGDPLT with helicopter drops. Finally, since this operating framework would require the Fed to be much more intentional about the rules it follows, it would make the Fed more rules-based and predictable. 

This proposal would require approval from Congress. Given the Fed's shrinking toolbox and the ongoing expectation that it deliver countercyclical policy, this may not be as big an ask as some imagine. Moreover, it could easily be seen as return to a more Monetarist Federal Reserve since it would be relying more explicitly on the monetary base to implement monetary policy. 

Some commentators have speculated that the corona virus might be a shock that forces us out of our complacency and spawns many unintended innovations. To the extent this shock leads to ongoing declines in the treasury yields and exhausts the Fed current toolbox, it might also lead to innovations in U.S. monetary policy. Here's hoping it does along the lines suggested above. 

1 The safe asset shortge can also become self-perpetuating and lead to what Caballero et al (2017) call a ‘safety trap’. This problem emerges when the excess demand for safe assets pushes down safe asset yields to the effective lower bound (ELB) on interest rates. If the excess demand for safe assets is not satiated at that point (i.e. the equilibrium real safe asset interest rate is below the ELB), then aggregate demand will contract and push down inflation. Via the Fisher relationship, the lower inflation will drive up the real safe asset interest rate and increase the spread between it and the equilibrium real safe asset interest rate. As a result, aggregated demand will further contract and the cycle will repeat.  This is the safety trap.


  1. Excellent blogging!

    My only add-on is that the helicopter drops should happen through a holiday on Social Security payroll taxes. The Fed can print money and stuff it into the Social Security trust fund to make up for lost receipts.

    Best implementation of the helicopter drops would be very easy and would only go to those people who are productive.

    Stanley Fischer has ideas similar to yours.

    Look for The Tinfoil-Hat Economist on YouTube in a few more days. I will address this issue also.

  2. Great post, David.

    What do you think of John Cochrane's "Stimu-lend" idea ( I sort of like the idea of lending money to taxpayers who want it, setting the interest rate to target NGDP, using the existing tax system to collect repayment. The rate could be zero or negative if required to hit the NGDP target. This seems like a much more efficient way to hit the NGDP target than outright transfers as it is easier to mop up excess liquidity if the natural rate suddenly rises.

    1. Ken, it is an interesting idea but it adds an extra layer of decision making and bureaucracy that may make it less timely and less accessible to some people. I worry it would turn out like the HAMP program for housing during the Great Recession.

      Regarding concerns about excess liquidity, my proposed standing fiscal facility that the Fed could use at ZLB or below can be used both for funding helicopter drops as well as for mopping up the funds. If for some reason, the Fed found itself facing runaway NGDP growth the SFF could issue treasury securities that the Fed could then sell to the public and reduce the monetary base.

  3. David, always learning a lot from your post! I just have one single question that has been lingering in my mind lately. If today's market move is so influenced by corona virus and massive decline of oil price leading to the credit risk of companies, why can't just Fed include corporate bonds in the basket of their asset purchase program? Are there any technical difficulties in doing so or hesistant to do so due to moral hazard problems?

    1. 90tillinfinity,

      Many have suggested the same thing, but the constraint is legal. The Fed is prohibited from buying corporate bonds and equities. Boston Fed President, Eric Rosengreen, for example, recently echoed your point by arguing the Fed should be able to buy more assets.

      George Selgin has an interesting proposal for how to do it. He would implement 'flexible open market operations' that would expand the types of assets the Fed could buy as well as the counterparties. See here

  4. Great post! I hope our betters are listening...

  5. Rates on bonds are going down. Rates are a way of expressing prices. Declining rates means prices are increasing. Simple supply and demand ought to be the first place to look for an explanation. Liquidity is chasing a fairly fixed supply of long bonds. If we want to meliorate the problem, we want Treasury to create and sell more bonds. Lots of them. This is one place where the solution to one problem is helpful in dealing with another problem.

    The other problem is that the Federal deficit is now running at a Trillion Dollars a year. If it continues to grow, debt service will grow and assume larger and larger portions of the annual budget. With rates now at historic lows, Treasury should print and sell long term bonds -- Trillions of Dollars of them. By doing that, interest payments will be locked at low rates for what could be a very long time. Bonds with maturities of 20 or 30 years are very cheap, 1.10% and 1.34% on Monday March 16, respectively. Issuing them now would lock in low rates right through the predictable social security crisis of 2035, when the OASDI trust fund is exhausted and benefits will have to be cut by ~25%. An event which will unleash a major political trauma.

    Not only that, but every bond issued is a tax increase enacted. Either luckless pedestrians will pay their FICA and Income Taxes and the bond holders will be paid off, or the bond will be defaulted thus imposing a 100% wealth tax on bondholders.

    Locking in low rates is therefore like a tax cut. And, if the coronavirus panic is driving the economy into recession, the taxcut of locked in low rates will be a stimulus and a tonic for the economy.

    The conclusion is easy. Treasury should endeavor to sell as many 10 and 30 year bonds as they can as quickly as they can.


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