The previous example occurred in the middle of what became known as “goldilocks” economics, not too hot and not too cold. It shows an example of a central bank taking early action to choke off inflationary pressures. While inflation remained in check through the 1990s the economy enjoyed one of its longest ever periods of sustained growth. The previous example demonstrated the success of the Fed’s monetary policy at that time. It had a much harder job in the period November 1998 through to July 2003 with the threat of a deflationary recession a real possibility:
November 1998–October 1999. The Fed left the discount rate unchanged through this period. Rates at the long-end star ted to drift up and despite their low nominal level they were relatively high in real terms and suggested rising inflationary expectations.
November 1999–January 2001. Over the course of a year the Fed increased the discount rate by approximately 150 bpts. These hikes continued through the first half of 2000 even though long-term rates had peaked in Januar y and (with the benefit of hindsight) appeared to be heading down. By Januar y 2001 long-term rates had fallen about 150 bpts from the peak and it appeared as though the Fed had overdone its tightening. The yield curve was inver ted in January 2001. This coincided with the bursting of the technology and stock market bubble.
February 2001–December 2001. Over the course of 2001 the Fed continued to cut rates aggressively and by the end of the year had cut nearly 500 bpts in total. At 1.25% the discount rate was at a historic low. Despite these cuts long-run rates continued to fall and by June 2002 had fallen a further 100 bpts. With very mixed signals of the economic outlook the Fed cut a further 50 bpts in November 2002 but these had little visible effect. The shape of the yield curve at the end of July 2003 remained largely unchanged from June 2002. The outlook in July 2003 remained very mixed with risks of a deflationary recession balanced by hopes of a modest recovery.
October 27, 2008
Fed Action and the Yield Curve, November 1998–July 2003
August 27, 2008
Fed Action and the Yield Curve, May 1994–February 1996
I’m going use two examples of Federal Reserve board action to illustrate how central banks can effect the yield curve. The first example dates back to 1994–1996. The yield curve charts tell us much pretty much what took place and how the yield curve influenced, and was affected by, Fed actions:
July 1992–January 1994. The Fed left the discount rate unchanged through this period. The yield curve had a normal upward structure with long-term rates steady to drifting down. They reached a low in January 1994.
April–May 1994. By April 1994 rates at the long end had increased by more than 100 bpts from their January lows signaling market expectations of higher inflation. In May 1994 the Fed increased the discount rate by 50 bpts.
June 1994–February 1995. Yields at the long end continued to rise driven by fears of inflation and an overheating economy. The Fed continued to increase rates by a fur ther 50 bpts in September, 25 bpts in November, a further 50 bpts in December and a further 50 bpts in February. The total increase was 225 bpts over less than a year, from a low of 3% to 5.25%.
March 1995–February 1996. By March 1995 the tightening of liquidity was star ting to have an effect, inflationary expectations were abating and long-term rates had fallen back to 7% around the level at which the Fed started tightening. The Fed left rates unchanged at 5.25% until February 1996 when long-term rates had fallen and were below 6%. In February 1996 it cut rates for the first time since July 1992.
Impact on term spreads. Between January 1994 and February 1996 the term spread between discount rates and 10-year bond yields had narrowed from approximately 280 bpts to around 80 bpts. The yield curve did not invert but it came close to being flat. People at the Fed had good reason to be satisfied with themselves. By taking early action they reduced the threat of inflation and cooled off an economy at risk of overheating but without pushing the economy into a recession or even a downturn.