Con-tango

Greenspan’s conundrum II

Alan Greenspan
Source: US Treasury

…I think we all owe a lot to the old Fed chairman.

The more I learn economics, the more I realize the many murky
circumstances that economists have to face. I think these uncertainties
are present, mainly, because economics is inextricably intertwined with
trading; which follows one basic rule: to make money—which is quite
unforgiving and unruly. Then, it would seem wise for economists to get
much closer to their mercantilist and financial cousins, for a brush of
the street’s worldly nature…

On the disquieting economic occasions—when recessions seem to loom
in the horizon, I’ve always felt economists claim to know better than
they do; if for no other reason, than to give us all peace of mind.

So, looking back at his record, and against the dim backlight of the
knowledge available to him, we can appreciate even more his outstanding
achievement.

And I’d also like to add myself to the long list, which agrees with John Taylor’s following remarks, at his Lessons learned from the Greenspan era presentation:

Alan
Blinder and Ricardo Reis have provided us with a comprehensive
evaluation of the Greenspan era, shedding light on key policy issues
and controversies. I particularly liked their behind-the-scenes review
of the move toward greater transparency. And I agree with their overall
evaluation of Alan Greenspan that “when the score is toted up, we think
he has legitimate claim to be the greatest central banker who ever
lived.”

I also recommend reading this colorful side of his personal life.

… He sure had a grasp of what was going on, at times difficult to
read; although, I think it was more my ignorance than lack of
communication skills on his part.

Getting back on the subject of his remarks…

Fourth, on 28 November 2005 Mr. Greenspan sent additional answers
to Jim Saxton related to his November 3 report to Congress, which I feel are quite clarifying.

But before we go any further, let’s take a look at how the yield
curves had evolved up until then—yikes! the shifting is well underway
by now, a noticeable flat pattern has emerged.

Here’s what he had to say in his letter:

(I helped myself to Mark Thomas’s clean transcript)

November 28, 2005

The Honorable Jim Saxton
Chairman
Joint Economic Committee
Washington, D.C. 20510

Dear Mr. Chairman:

I am pleased to enclose my responses to the additional questions you forwarded in connection with the November 3 hearing.

I also wanted to thank you, and the other members of
the committee, for your kind and generous comments at the hearing and
in your letter. It has been a pleasure appearing before the Joint
Economic Committee over the years.

Sincerely,

Alan Greenspan

Chairman Greenspan subsequently submitted the
following to written questions received from Chairman Saxton in
connection with the Joint Economic Committee hearing on November 3,
2005:

Q.1. Since the "neutral" rate is not observable, how
do you know when you’ve reached the neutral rate? What variables do you
monitor to make judgments as to how close to neutral the fed funds rate
is? As the fed funds rate is ratcheted up, and given the lags that
exist, does the possibility of raising it above a neutral level
increase?

A.1. Although the concept of a "neutral interest
rate" is a useful theoretical construct, difficulties in implementing
it in practice limit its usefulness as a framework for monetary
policymaking. For one thing, a variety of definitions of a neutral real
interest rate are possible. For another, quantitative estimates of the
level of such a rate are subject to considerable uncertainty. Also,
such estimates can vary widely depending on the type of measure and the
prevailing and projected economic conditions. In particular, all
variables that contribute to making a macroeconomic forecast relevant
for estimates of neutral interest rates, greatly complicating such
assessments. Thus, it is impossible to know with any certainty when the
neutral rate has been reached. Moreover, the use of neutral real rates
in the formulation of monetary policy in not necessarily
straightforward. For instance, in some circumstances, attaining a
"neutral" federal funds rate would in principle be an appropriate
objective for monetary p0licy, but in others–particularly when
inflation is too high or too low–aiming for a neutral funds rate in
the near term would not be appropriate. These uncertainties and
complications suggest that reliance on a single summary measure such as
a neutral real interest rate would be unwise as a strategy for
formulating monetary policy. Rather, a full consideration of current
and perspective economic developments, and of the risks to the outlook,
is essential for the conduct of monetary policy.

Q.2. Over the last year and a half, the Federal
Reserve has raised the federal funds rate by 3.0 percentage points and
indicated that further increases are likely in order to check
inflation. Yet long-term rates, including mortgages, are lower now than
when the FOMC began tightening. In past comments, you have termed this
situation a "conundrum" without recent precedent. What explains the low
level of long-term interest rates?

A.2. As I noted in my monetary policy testimony
before the Congress in July, two distinct but overlapping developments
appear to be at work in explaining the low level of long-term interest
rates:  a longer-term trend decline in bond yields and an acceleration
of that trend over the period since mid-2004. Both developments are
particularly evident in the nominal interest rate applying to the
one-year period ending ten years from today that can be inferred from
the U.S. Treasury yield curve. In 1994, that so-called forward rate
exceeded 8 percent. By mid-2004, it had declined to about 6-1/2
percent–an easing of about 15 basis points per year on average. Over
the past year, that drop steepened, and the forward rate fell 130 basis
points to less than 5 percent.

Some, but not all, of the decade-long trend decline
in that forward yield can be ascribed to expectations of lower
inflation, a reduced risk premium resulting from less inflation
volatility, and a smaller real term premium that seems due to a
moderation of the business cycle over the past few decades. As I noted
in my testimony before the Joint Economic Committee in February, the
effective productive capacity of the global economy has substantially
increased, in part because of the breakup of the Soviet Union and the
integration of China and India into the global marketplace. And this
increase in capacity, in turn, has doubtless contributed to
expectations of lower inflation and lower inflation-risk premiums.

In addition to these factors, the trend reduction
worldwide in long-term yields surely reflects an excess of intended
saving over intended investment. This configuration is equivalent to an
excess of the supply of funds relative to the demand for investment.
Because the intended capital investment is to some extent driven by
forces independent of those governing intended saving, the gap between
intended saving and investment can be quite wide and variable. It is
real interest rates that bring actual capital investment worldwide and
its means of financing, global saving, into equality. We can directly
observe only the actual flows, not the saving and investment
tendencies. As best we can judge, both high levels of intended saving
and low levels of intended investment have combined to lower long-term
interest rates over the past decade.

Q.3. I was intrigued by your response to my question
relating to the yield curve and associated yield spread between the fed
funds rate and the 10-year bond yield. In particular, your response to
the spread question was as follows:

"…that used to be one of the…most accurate
measures we used to have to indicate when a recession was about to
occur and when a recovery was about to occur. It has lost its
capability of doing so in recent years…it has significant financial
impacts, it’s no longer useful as a leading indicator to the extent
that it was."

In pondering this comment, three considerations
appear to be especially relevant: (1) First, the importance of a yield
spread for monetary policy has long been recognized by classical
economists. Both Henry Thornton and Knut Wicksell recognized that when
the central-bank-controlled short-rate moves relative to a long-term
market rate, relative prices, incentives, and behaviors change. (2)
Second, the recent (2005) extensive review and summary of the
literature pertaining to research on the yield spread (published by the
Federal Reserve Bank of New York) concludes that the weight of the
evidence supports the potency of the yield spread.  (See Estrella,
October 2005).  (3) Third, the Conference Board includes a yield spread
variable in its index of leading economic indicators. The Conference
Board conducts an ongoing evaluation of these indicators and an
especially thorough, major reevaluation of the composite was made last
July. The bottom line is that the yield spread remains a key component
of this composite.

In light of these considerations, what available
evidence or other factors support the view that the yield spread is no
longer especially useful?  Has the Board staff assessed this
relationship recently?

A.3. Although the slope of the yield curve remains an
important financial indicator, it needs to be interpreted carefully. In
particular, a flattening of the yield curve is a not a foolproof
indicator of future weakness. For example, the yield curve narrowed
sharply over the period 1992-1994 even as the economy was entering the
longest sustained expansion of the postwar period.

Three basic factors affect the slope of the
yield-curve–the current level of the real federal funds rate relative
to the long-run level, the level of near-term inflation expectations
relative to expected inflation at longer horizons, and the level of the
near-term risk premiums relative to risk premiums at longer horizons.

Statistical analysis indicates that the first
factor–the gap between the current and long-run levels of the real
federal funds rate–is a key component from which the yield curve slope
derives much of its predictive power for future GDP growth. When the
level of the real federal funds rate is pushed well below its long-run
level, economic stimulus is imparted and the yield curve steepens. The
economic stimulus influences output growth with a lag; as a result, the
steepening of the yield curve in this scenario is a predictor, albeit
not the cause of, stronger economic activity ahead. Conversely, when
the level of the real federal funds rate is pushed above its long-run
level, economic restraint is imparted and the yield curve flattens.
Once again, the economic restraint influences output growth with a lag,
so the flattening (inversion) of the yield curve in this scenario would
signal weaker economic growth ahead, but would not itself be the cause
of the weakening.

The connection between future output growth and the
other two factors affecting the slope of the yield curve–the gap
between near-term and long-term inflation expectations and the
difference between near-term and long-term risk premiums–is far less
certain and likely to depend on economic circumstances. For example, a
rise in near-term inflation expectations above long-term inflation
expectations would tend to flatten the yield curve and might also
signal a prospective weakening in aggregate demand.  This configuration
in inflation expectations might reflect adverse supply factors that
have pushed up inflation in the near term but that are expected to
dissipate over time. In this case, the flattening of the yield curve
might well be a signal of an improving inflation picture that could
also be accompanied by a favorite outlook for economic growth.

The connection between output growth and risk
premiums is also quite uncertain. A fall in distant horizon risk
premiums would flatten the yield curve and might signal a weakening in
economic activity if, for example, the drop in risk premiums in
fixed-income markets was associated with a "flight to safety" on the
part of global investors seeking a safe haven from turbulence in equity
markets and other risky assets. But it is also possible that a decline
in distant horizon risk premiums could be a sign that investors are
generally more willing to bear risk. In this case, a flattening of the
yield curve stemming from this factor could be an indicator of an
easing in financial conditions that would stimulate future economic
activity.

In summary, many factors can affect the slope of the
yield curve, and these factors do not all have the same implications
for future output growth. In judging the indicator value of any
particular change in the slope of the yield curve, it is critical to
understand the underlying forces that may be affecting the yield curve
at the moment. As the 1992-1994 episode attests, simply relying on an
average statistical relationship estimated over a very long sample can
be quite misleading.

Q.4. One of the strategies or institutional changes
that you have supported in recent years relates to the increased
transparency of the Federal reserve. This increase Federal Reserve
transparency has, for the most part, been associated with more benefits
than costs. Doesn’t this increased transparency work to the benefit of
both the Federal Reserve and the public?

A.4. Greater transparency with regard to Federal
Reserve actions encourages public discussion and informed scrutiny,
important aspects of accountability in a democratic society.
Transparency also enables financial markets to better predict monetary
policy decisions, which can contribute to improved policy outcomes.
However, providing more complete information about policy decisions is
not without cost. Transparency requires careful attention by
policymakers, and so constrains the time they have for actually making
decisions. More importantly, excessive transparency could inhibit
policymakers, making them less spontaneous in their remarks and less
willing to explore new ideas. Such an outcome would have adverse
effects on policy decisions. The Federal Reserve’s current practices
strike a reasonable balance between transparency and the degree of
confidentiality appropriate to support the policy process.

So, what is he trying to tell us?

To start with, let’s look into his following statement:

• …the gap between the current and long-run levels of the real
  federal funds rate–is a key component from which the yield curve slope
  derives much of its predictive power for future GDP growth…

Could GDP growth be explained by crossovers to a trailing monthly Fed rate average?

To be continued…

But before ending this post, I’ll leave you guys with the latest yield curves:

Notice that the 30 year bond has been resurrected.  I’m willing to bet that the  addition of this bond, which increases the offer of bonds on the long end, diffused the downward pressure on long-term yields.

Now, ask yourselves: why did the Fed hold back the emission of the 30 year bond for so long—could it be that they held back, as long as they did, in order to gain from the low 10 year rates?