http://www.real-business.info Sat, 01 Aug 2009 11:50:10 +0000 en hourly 1 http://wordpress.org/?v=3.3.1 http://www.real-business.info/fed-action-and-the-yield-curve-may-1994%e2%80%93february-1996/ http://www.real-business.info/fed-action-and-the-yield-curve-may-1994%e2%80%93february-1996/#comments Wed, 27 Aug 2008 11:38:21 +0000 admin http://real-business.info/?p=10 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.

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