Article analisis 6

Interest Rates, Yield Curves, and the Monetary Regime by Joseph G. Haubrich

June 2004

ISSN 0428-1276

Talk to just about any Federal Reserve economist, and they will tell

you that at cocktail parties, school

fundraisers, and whatnot, the question

they always get asked is “where are

interest rates going?” Now while the

Fed economist may have little wisdom

to impart, it is true that the Federal

Reserve does target interest rates. The

rate that the Fed targets, however, the

federal funds rate, is of direct interest

only to bankers and other investment

professionals (who seem over-repre-

sented in certain Cub Scout packs, but

that’s another story). The rates people

worry about are the ones that more

directly affect them—mortgages, auto

loans, credit cards.

Of course, the Federal Reserve does

affect these interest rates, but the con-

nection between the short-term rates

targeted by the Fed and the longer-

term rates most people worry about is

complicated and involves some subtle

factors. It’s generally understood that

when the Fed changes the federal

funds rate, other rates in the econ-

omy also change. What’s less appre-

ciated is that the way interest rates

change depends not just on what the

Fed does today, or even next month

or next year, but also on people’s per-

ceptions about the goals and credibil-

ity of the monetary authority. These

goals and the accompanying expecta-

tions in turn depend on the institutional

arrangements of monetary policy—

some countries have laws mandating

low infl ation, others have a tradition

of keeping infl ation low, still others

have nothing of the kind. This Eco-

nomic Commentary looks at how such

arrangements infl uence the impact of

Federal Reserve actions on the broader

fi nancial markets. In a phrase, it looks

at the impact of monetary regimes.

� Regimes Probably the best way to think of a

monetary regime is as a set of institu-

tional arrangements—how monetary

policy is set up—along with the cor-

responding expectations of the pub-

lic. Thus it’s not just what is called the

monetary standard, which comprises

the laws, regulations, and bureaucracy

governing the money supply, but also

includes expectations—does the public

believe the commitment to zero infl a-

tion, or not?

The concept of a monetary regime is

quite broad. The situations encom-

passed range from systems where

money consists of unbacked, rather

fl imsy pieces of paper to those where

people knew the money supply would

change only if someone sailed to a dis-

tant island and returned with disk hewn

from solid rock (as was the case on the

Isle of Yap). Usually though, monetary

regimes tend to be a variation of two

(somewhat idealized) types: commod-

ity standards and fi at systems.

Commodity standards presuppose that

money is freely convertible into a com-

modity—usually gold, but silver is also

common. Under a gold standard, for

example, the money supply is fi xed by

the supply of gold in the world. This

provides a nominal anchor to the price

level, effectively preventing long-term

infl ation since it ties money to gold.

Of course, some infl ation is still pos-

sible in the short run because trans-

port costs, shipping delays, and so on

mean that money isn’t immediately

converted into gold, but barring major

gold discoveries, the infl ation will dis-

sipate quickly.

A fi at regime has no backing for

money. That is, the government or

central bank will only exchange your

paper money for other paper money,

not gold or silver. (The word fi at

comes from the Latin for “let it be

done,” indicating that the government

just declares that the paper is money.)

A gold standard is not the only regime

that will keep infl ation low. A fi at

regime, where money is not backed,

can still be credible if there is a com-

mitment to low infl ation. This commit-

ment might be informal, just a consen-

sus of those in charge or the product

of culture and tradition. The commit-

ment to low infl ation might be man-

The yield curve has a wealth of information about future interest rates and economic conditions. Users should exercise caution, though, as many of the rela- tionships that hold between the behavior of the curve and what it fortells depend on the monetary regime in place at the time the curve is drawn.

dated by law, as in Canada, Great Brit-

ain, and New Zealand. Just as in the

gold standard case, sometimes infl ation

will occur, but the central bank acts to

bring it down. And people expect that

to happen.

Regimes are not always be credible.

For example, when the price level

and money supply are not tied down

by law or by a gold standard, infl a-

tion can, and has, gotten out of control.

Thus the economy, in addition to short-

term infl ation, may see infl ation over

the longer term. People realize that

infl ation has increased and is unlikely

to decrease for quite some time. Nei-

ther the workings of a gold standard or

the commitment of the central bank are

in place to force infl ation back down.

In some sense, then, a good measure of

the credibility of a regime is the per-

sistence of infl ation. In both the gold

standard and the credible fi at regime,

a burst of infl ation does not last, as

either the standard or the central bank

soon gets prices under control. With

a noncredible fi at regime, however,

things are different. Higher infl a-

tion may last for a long time. What

was temporary infl ation in a credible

regime becomes persistent infl ation in

a less credible regime.

As the reader might have guessed,

these regimes are not purely imaginary,

though they may be starker than what

is actually seen in practice. The United

States was on some form of a gold

standard from 1879 until 1933. For

most of that period infl ation remained

low (see fi gure 1). The major excep-

tion was World War I and its aftermath,

when infl ation at times reached nearly

30 percent. This refl ected massive gold

imports from Europeans looking for

a safe harbor for their assets. Shortly

after the war, though, as the Europeans

countries returned to the gold standard,

prices fell, and it was defl ation that hit

double digits in the United States dur-

ing the early 1920s.

After 1933, when Americans could no

longer exchange their dollars for gold,

(or even own gold) the United States

still retained a tenuous link to the gold

standard in that currency was required

to have a partial gold backing. The

government was required to hold a cer-

tain amount of gold for each Federal

Reserve note issued to the public. This

requirement was eliminated in 1968.

After this time, foreign central banks

could still exchange dollars for gold,

but even this ended in August of 1971.

At least since 1972, the United States

has been on a fi at regime. This has at

times looked like both the credible and

the noncredible fi at regime described

above. For most of the 1970s, infl ation

was high and it persisted at high levels

for most of the decade. Since the mid-

dle 1980s, however, infl ation has been

lower, and its increases only temporary.

� Riding the Yield Curve The different types of monetary

regimes embody different patterns of

action by the central bank and different

expectations of the public. These pat-

terns strongly color how interest rates

will move. Understanding the infl u-

ence of these patterns means taking a

closer look at different interest rates.

As mentioned above, there are many

types of interest rates in the fi nan-

cial marketplace: Think of mortgages,

savings bonds, auto loans, and junk

bonds. There are interest rates on safe

investments (savings bonds) and risky

investments (junk bonds), short-term

rates and long-term rates, rates backed

by hard collateral (auto loans) and

those backed by promises to pay. For

our purposes, though, the most impor-

tant patterns arise when we concentrate

on different maturities: short versus

long rates. And to avoid differences in

risk and so forth, it makes sense to fur-

ther focus on just U.S. Treasury debt,

which is considered default free. Plot-

ting these rates against their maturity

produces the yield curve. Understand-

ing how the yield curve moves and

reacts to different economic events pro-

vides a glimpse into the relationships

between long- and short-term interest

rates. For example, short-term inter-

est rates might be quite low, but that

does not guarantee low long-term rates:

a steeply sloped yield curve will have

long rates much higher than short rates.

What does this talk of interest rates

have to do with regimes? The mon-

etary regime has a lot to do with the

shape and movement of the yield

curve, and thus with how closely short

and long-term rates move together (or

don’t).

The fi rst step in this process is recall-

ing how infl ation affects interest rates.

When prices rise, dollars in the future

buy less than dollars today, so get-

ting 10 percent interest does not buy

you 10 percent more stuff. The “real”

return or real yield is less than the 10

percent because of the value infl ation

takes away. Smart investors know this,

and take account of expected infl ation

when making fi nancial transactions. As

a result (the famous Fisher equation)

the nominal interest rate on a bond or

money market account can be thought

of as being composed of a real rate and

an expected infl ation rate. A 10 percent

interest rate with no infl ation gives you

the same real return as a 15 percent

interest rate when infl ation runs at 5

percent.

This is where regimes, their credibility,

and the persistence of infl ation come

in. Under a credible regime, such as a

gold standard, infl ation may be high at

times, but it is only temporary. Thus,

shorter-term rates—three months, one

year, and so forth, should build in that

infl ation premium, and increase. Over

the long haul, however, infl ation will

revert to low levels, so there shouldn’t

be much of an infl ation premium on

10-, 20-, or 30-year bonds.

This means that under a credible

regime, infl ation shocks end up fl atten-

ing the yield curve temporarily. (Con-

versely, a shot of defl ation will make

the curve steeper.)

Things are different under a less cred-

ible regime, where infl ation is more

persistent. Infl ation hangs around lon-

ger, so that high infl ation today means

high infl ation tomorrow as well. The

infl ation premium not only gets built

in to short rates, but to longer rates as

well. Unlike the credible case, where

infl ation moved up only short-term

interest rates, in the noncredible case,

infl ation moves up long and short

rates. This shifts the entire yield curve

up. The curve does not, however, get

appreciably steeper or fl atter, as rates

move up with infl ation.

That last point deserves a bit more

explanation. Whether the curve gets

steeper or fl atter depends on how per-

sistent infl ation is. In one extreme case,

where higher infl ation today causes

people to expect that higher rate for-

ever, the slope does not change. If

infl ation is less persistent, the long

rates won’t rise as much as short rates,

and the curve will move up and fl atten,

though not as much as in the credible

SOURCES: Balke and Gordon (1986); and the U.S. Department of Commerce, Bureau of

Economic Analysis.

FIGURE 1 INFLATION IN THE UNITED STATES

case. It’s even possible that people see

a small rise in infl ation today and think

this presages even more infl ation, so

the curve gets steeper.

� Digging in the Data Now all this matters precisely because

many people are anxious to extract any

information they can from the yield

curve. So the fi rst set of people who can

benefi t from understanding the relation

between regimes and the yield curve are

those fi nancial analysts, market watch-

ers, and homeowners looking to refi -

nance who are concerned with the rela-

tionship between long and short rates.

The lesson for them is that the regime

matters a lot when thinking about the

connection between long rates and

short rates. Seeing short rates rise

today doesn’t always tell you much

about long rates, and this is particu-

larly true in times of low and stable

infl ation. For example, over the past

decade and a half, 10-year interest

rates have shown both large increases

and decreases in response to changes

in the federal funds rate, the overnight

rate targeted by the Fed’s Federal Open

Market Committee.

Another set of people who should heed

the message about regimes are those

who use the yield curve to help fore-

cast the future. This probably includes

many of those responsible for mon-

etary policy. Because fi nancial markets

are by their very nature forward look-

ing, they embody the expectations of

a great many people, and thus contain

a lot of information about the future.

Many people in fact use the slope

of the yield curve—the difference

between long and short rates—to fore-

cast economic growth. The idea is that

an inverted yield curve can signal an

upcoming recession. More generally, a

fl at (or inverted) yield curve presages

slow growth, with a steep curve pre-

dicting faster economic growth. The

reasons for this are not entirely clear,

but in part, this may refl ect monetary

policy: A steep yield curve means the

central bank is keeping short-term

rates below average, indicating expan-

sionary policy. How reliable this yield

curve signal is varies over time, how-

ever, and the reliability depends a lot

on which monetary regime we’re in.

Recall that under a credible nominal

regime, with a gold standard or infl a-

tion target, infl ation, being temporary,

will increase short rates but leave long

rates unchanged. Bursts of infl ation

then add noise to the signal the yield

curve is giving—some purely nomi-

nal shifts are added to the movements

forecasting the real economy. Under a

credible regime, then, the yield curve

should have some trouble forecasting

the real economy.

With a regime that is not credible,

the situation is different. Since infl a-

tion is more persistent, it tends to hang

around for a while, and this drives up

long-term rates along with short-term

rates. That is, yields shift up together

all along the curve, keeping the slope

roughly constant. That means persistent

infl ation does little to change the slope

of the yield curve, keeping its predictive

properties intact. So under a noncred-

ible regime the yield curve does better

in forecasting the real economy.

The differences in credibility perhaps

underlie the somewhat murky perfor-

mance of the yield curve in predict-

ing the most recent recessions. In the

early 1980s, when the credibility of the

Federal Reserve was not as strong, the

yield curve gave clear signals of reces-

sions. The recession starting in Janu-

ary 1980 was heralded by an inverted

yield curve a year earlier, in January

of 1979, and short rates exceeded long

rates by almost a full point by Septem-

ber of 1979. Similarly, the recession of

July 1981 was preceded by an inverted

yield curve, where short rates exceeded

long rates by over two and half percent

in December 1980.

In contrast, when the Federal Reserve

had attained greater credibility, predic-

tions from the yield curve were not so

clear. Prior to the 1990 recession, for

example, the yield curve did not invert,

though it did fl atten considerably. Prior

to the most recent recession starting

in March 2001, the curve did invert,

but short rates exceeded long rates by

barely half a percentage point, and that

was in December of 2000, giving little

lead time.

� Clouds and Silver Linings The points made about regimes, infl a-

tion, and yield curves have neglected

some very important issues. There are

large advantages to having a regime

with stable low infl ation. Firms and

workers can set contracts without wor-

rying about infl ation eating away the

gains. The tax code won’t automati-

cally bump people into higher tax

brackets even if real incomes don’t

rise. The post offi ce won’t have to keep

raising the cost of stamps.

But these advantages come with some

costs, and one of these costs is a yield

curve that is more diffi cult to interpret.

Such a cost hardly justifi es a return

to double-digit infl ation, but it should

serve as a cautionary reminder that

some signals and indicators will prove

murkier in some regimes than others.

Percent

40

20

30

10

0

–10

–20

–30

1860 1880 1900 1920 1940 1960 1980 2000

Joseph G. Haubrich is a consultant and

economist at the Federal Reserve Bank of

Cleveland.

The views expressed here are those of the

author and not necessarily those of the

Federal Reserve Bank of Cleveland or

the Board of Governors of the Federal

Reserve System or its staff.

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� Notes 1. This Commentary is based on work

with Michael D Bordo of Rutgers Uni-

versity. A more detailed discussion of

the ideas can be found in the paper,

“The Yield Curve, Recession, and the

Credibility of the Monetary Regime:

Long-run Evidence, 1875–1997.” Fed-

eral Reserve Bank of Cleveland, Work-

ing Paper, no. 04-02, and NBER Work-

ing Paper no. 10431, April 2004.

2. The specifi c examples of spreads

and growth use monthly data for the

spread between 10-year and 3-month

Treasury securities. Other maturities

and more frequent data (daily, weekly)

would be a bit different, (that is, one

could fi nd a small, brief inversion prior

to the 1990 recession) but the basic

message would be the same.

3. The data for a portion of the infl a-

tion series used in fi gure 1 come from

Nathan S. Balke and Robert J. Gordon.

1996. “Historical Data,” in appendix

B of The American Business Cycle:

Continuity and Change, NBER Studies

in Business Cycles, vol. 25, edited by

Robert J. Gordon, University of Chi-

cago Press, Chicago.

Recommended Reading The concept of a monetary regime is

explored in more depth in:

Michael D. Bordo and Anna J.

Schwartz. 1999. “Monetary Policy

Regimes and Economic Performance:

The Historical Record,” in Handbook

of Monetary Economics, vol. 1, edited

by John B. Taylor and Michael Wood-

ford, Elsevier Science B.V.