Yellen Inherits Greenspan’s Conundrum as Long Rates Sink.

http://www.bloomberg.com/news/2014-11-19/yellen-inherits-greenspan-s-conundrum-as-long-rates-sink.html

Alan Greenspan couldn’t control long-term interest rates a decade ago, and bond investors are betting Janet Yellen’s luck will be no better.

When then-Federal Reserve Chairman Greenspan raised the benchmark overnight rate from 2004 to 2006, long-term borrowing costs failed to increase, thwarting his attempts to tighten credit and curb excesses that contributed to the worst financial crisis in 80 years.

“We wanted to control the federal funds rate, but ran into trouble because long-term rates did not, as they always had previously, respond to the rise in short-term rates,” Greenspan said in an interview last week. He called this a “conundrum” during congressional testimony in 2005.

The bond market is signaling that past may be prologue as Yellen’s Fed prepares to raise rates next year. The yield on the 10-year U.S. Treasury note has fallen 0.71 percentage point in 2014 even as the Fed wound down its bond-buying program and mapped out a strategy to raise the benchmark federal funds rate from near zero, where it has been since 2008.

Most Fed policy makers expect the central bank will raise the federal funds rate, which represents the cost of overnight loans among banks, some time next year, according to projections released in September.

The stakes are higher this time because rates are lower and the yield curve is flatter. Raising short-term rates in the face of stable or falling long-term rates could lead to a situation where the Fed “quickly inverts the yield curve and turns credit creation on its head,” said Tim Duy, an economics professor at the University of Oregon in Eugene and a former U.S. Treasury Department economist.

Bank Credit

An inverted yield curve occurs when short-term securities yield more than longer-dated bonds. That discourages banks from extending credit because they finance long-term loans with short-term debt. Inverted yield curves typically precede recessions.

Duy said the Fed has few options if long rates don’t rise after increases in the federal funds rate: the Fed would have little scope to raise the benchmark further, and not much room to cut if the economy were to slump.

Excess Savings

Saravelos said Europe’s surplus in its current account, the broadest measure of trade that includes investment income, is “bigger than China’s in the 2000s” at around $400 billion per year.

“The next few years will mark the beginning of very large European purchases of foreign assets,” he wrote in an Oct. 6 report.

Economic stagnation has reduced yields in places like Germany and Japan, which will help funnel excess savings into the U.S. and prevent Treasury yields from rising, according to Roberto Perli, a partner at Cornerstone Macro LP in Washington.

Inflation Outlook

A lack of inflationary pressure, excess savings and global stagnation have combined to reduce the compensation investors demand for unexpected changes in long-term interest rates, measured by a component of yields known as the term premium, according to a New York Fed model.

Term Premium

“If you want to know what moves long rates, in general it’s more term premiums than it is the path of policy,” Jeremy Stein, a Harvard economics professor and former Fed governor, said in an interview.

From policy makers’ current point of view, “a rising term premium is a problem. A falling one is not,” said Wright, now a professor at Johns Hopkins University in Baltimore. That’s why “the Fed is trying to be very, very careful in laying out as much as they can an expected path of tightening.”

Further Action

Still, the Fed may eventually need to take further action if the economy starts to overheat.

That’s where the central bank’s expanded balance sheet may be useful, according to Gapen, a former Fed economist.

Just as the Fed’s purchases are thought to have depressed term premiums, sales of Treasuries could reverse the downward pressure, Gapen said.

The potential to sell Treasuries “gives people confidence that if there is a serious problem, you have an additional policy tool,” he said.

 Alan Greenspan, former Federal Reserve chairman and president and founder of Greenspan Associates.

Janet Yellen, chair of the U.S. Federal Reserve.