It is time to let bygones be bygones

US bond yields continue to rise. To some this is a major risk for the global economy. However, I continue to think that there is no reason to worry about rising US bond yields – at least not from the perspective of the US economy.

Many have highligthed that the rise in US yields have been caused by the Federal Reserve’s plans to scale back quantatively easing. The fear of “tapering” is certainly a market theme and I would certainly not rule out that the tapering talk has contributed to the rise in bond yields. However, we don’t know that and a lot of other factors certainly also have contributed to the rise in yields and I do certainly not think that the recent rise in yields in itself is likely to derail the US economy. The Fed might still fail by prematurely tighten monetary conditions, but bond yields are not telling us much in that regard. Or rather if the market really feared premature monetary tightening then yields would probably have collapsed rather than continued to rise.

Back in May I wrote the following:

Greenspan was thinking that the Federal Reserve should (or actually did) target NGDP growth of 4.5%. Furthermore, he (indirectly) said that that would correspond to 30-year US Treasury yields being around 5.5%.

This is more or less also what we had all through the Great Moderation – or rather both 5% 30-year yields and 5% NGDP growth. However, the story is different today. While, NGDP growth expectations for the next 1-2 years are around 4-5% (ish) 30-year bond yields are around 3.3%. This in my view is a pretty good illustration that while the US economy is in recovery market participants remain very doubtful that we are about to return to a New Great Moderation of stable 5% NGDP growth.

That said, with yields continuing to rise faster than the acceleration in NGDP growth we can say that we are seeing a gradual return to something more like the Great Moderation. That obviously is great news.

In fact I would argue that when US 30-year hopefully again soon hit 5% then I think that we at that time will have to conclude that the Great Recession finally has come to an end. Last time US 30-year yields were at 5% was in the last year of the Great Moderation – 2007.

We are still very far away from 5% yields, but we are getting closer than we have been for a very long time – thanks to the fed’s change of policy regime in September last year.

Finally, when US 30-year bond yields hit 5% I will stop calling for US monetary easing. I will, however, not stop calling for a proper transparent and rule-based NGDP level targeting regime before we get that.

Since then US yields have continued to rise and even though 30-year yields are still someway away from 5% we getting closer on another measure, which is probably more relavant. Take a look at the graph below.

30yearyield

This is the market expectation for 30-year yields in five years. Since May we have seen a more 100bp increase in yields and we are now closing in on my “target” of 5%.

Historically there has been a very close relationship between nominal GDP growth and 30 year yields and it is reasonable to assume that when the market is expecting close to 5% yields in five years then it is a pretty strong indication that the market no longer expects a “Japanese scenario” of 10-15 years of deflation and no NGDP growth. In fact the market now more or less seem to expect that we are heading back towards nominal GDP growth rates similarly to what we had during the Great Moderation prior to 2008. Said in another way – we have moved out of the “expectational trap”. Investors no longer see weak nominal GDP growth as a permanent situation.

Therefore, I think it is safe to conclude that we effectively are at the end of the Great Recession in terms of market expectations. That, however, do not mean that we are out of the Great Recession in terms of the macroeconomic situation. Unemployment in the US likely is well-above the structural level of unemployment and the economy is certainly not working at full capacity. But judging from the bond market we are no longer caught in an expectational trap.

Obviously even though the US economy seems to be out of the expectational trap there is no guarantee that we could not slip back into troubled waters once again. In fact as the graph above shows that in 2009  5-year ahead 30-year yields swiftly recovered back to Great Moderation levels around 5%, but then fell back to “depression levels” in 2010 and then again in 2011/12 – both times seemingly driven primarily by the euro crisis.

It should, however, be stressed that the set-backs in 2010 and 2011/2012 happened at a time when the Fed had not clearly defined a monetary policy rule nor had the Fed defined a clear alternative monetary policy instrument to the interest rate tool. Now however, it is pretty clear to most market participants that the Fed would likely step up quantitative easing if shock would hit US aggregate demand and it is fairly clear that the Fed has become comfortable with using the money base as a policy instrument. The Evans rule is far from perfect, but it is certainly better than what we had in 2010 or 2011.

In that regard it is notable that yields started the  up-trend around September last year then the Fed basically announced the Evans rule, cf. the graph above. It is also notable that there probably has been a “recognition lag” – the markets did not immediately priced in 4-5% future NGDP growth. This has only happened gradually (indicating the Fed did not explain its target well enough), but we now seem to be quite close to having fully priced in longer-term growth rates in NGDP similar to what we had during the Great Moderation.

And finally, I must admit that I increasingly think – and most of my Market Monetarist blogging friends will likely disagree – that the need for a Rooseveltian style monetary positive shock to the US economy is fairly small as expectations now generally have adjusted to long-term NGDP growth rates around 4-5%. So while additional monetary stimulus very likely would “work” and might even be warranted I have much bigger concerns than the lack of additional monetary “stimulus”.

Hence, the focus of the Fed should not be to lift NGDP by X% more or less in a one-off positive shock. Instead the Fed should be completely focused on defining its monetary policy rule. A proper rule would be to target of 4-5% NGDP growth – level targeting from the present level of NGDP. In that sense I now favour to let bygones to be bygones as expectations now seems to have more or less fully adjusted and five years have after all gone since the 2008 shock.

Therefore, it is not really meaningful to talk about bringing the NGDP level back to a rather arbitrary level (for example the pre-crisis trend level). That might have made sense a year ago when we clearly was caught in an expectations deflationary style trap, but that is not the case today. For Market Monetarists it was never about “monetary stimulus”, but rather about ensuring a rule based monetary policy.  Market Monetarists are not “doves” (or “hawks”). These terms are only fitting for people who like discretionary monetary policies.

PS Just because I now argue that we should let bygones be bygones I certainly do not plan to let the Fed of the hook. Rather the opposite, but my concern is not that monetary policy is too tight in the US. My concern is that monetary policy still is far too discretionary.

PPS If the Fed once again “slips” and let monetary conditions become excessively tight as in 2011/12 I would certainly scream about that.

PPPS My worries that Larry Summers might become the next Fed chairman certain have influenced my thinking about these issues. I don’t fear that Summers will be too hawkish or too dovish. I fear that we will go back to an ultra-discretionary monetary policy in the US. The result of this could be catastrophic.

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9 Comments

  1. Jens Pedersen

     /  September 10, 2013

    Lars,

    This blog post is spot on. There is a rule in place and markets are telling us that the US is back to normal in five years time. It is definitely five years too long, but the recovery is on track and people should stop worrying about rising yields.

    J

    Reply
  2. Seems legit. Expected rising income growth are putting upward pressure on rates, and from what I’ve seen, this probably matters more than worries over the rate at which liquidity is reabsorbed from the loanable funds market.

    On the other hand, now we have to worry about all this “macroprudential” nonsense, which as far as I can tell is all about putting nonmarket actors in a position to allocate credit. The discretionary beast is still a-roarin’.

    Reply
  3. I more or less agree Lars, especially that we should forget about returning to the old trend NGDP, though I think the drop in the Spain-Germany 10-year spread has been important for U.S. yield normalization. In so far as correlation between U.S. yields and that spread in 2012 was driven by the ‘depress U.S. V’ effect (that is lower NGDP expectation), the Evans rule was useful, but surely some of the low U.S. yields last year were from a ‘haven premium’ being priced into treasuries as traders moved out of risky European bonds. U.S. Stocks did fairly ok in 2012 so I think this effect was sizable. In so far as this is true, higher yields aren’t really particularly meaningful for U.S. policy, just a draw down in the haven premium.

    Reply
  4. brendan

     /  September 11, 2013

    I can’t disagree with the basic point, but in the last few years Eurozone events- negative correlation between rates in US and default risk in Europe- have polluted the relation between US NGDP growth expectations and US 30 year rates enough to make the rate-NGDP proxy less reliable than its been historically.

    For instance, 5 year forward US 30 year rate expectations are lower today than in 12/09. Should we conclude that a Japan style deflation trap is perceived more likely today than in 12/09? Seems ridiculous. More likely, Euro sovereign default risk hadn’t spiked yet in 12/09.

    Certainly part of the rise in US rates since the Evans rule was announced reflects improved conditions in Europe.

    Again, I think you’re probably right, but the noisiness of the rate-NGDP proxy in recent years makes me less certain.

    Reply
  5. brendan

     /  September 11, 2013

    Ah, Justin says same thing better than me.

    One other point occurs to me. Despite recent improvement, European sovereign bonds are still perceived as much riskier than when Greenspan said 4.5% NGDP= 5.5% 30 year rates. That would imply that nowadays, 4.5% NGDP would imply lower 30 year rates in the US. And as Justin points out the safe haven premium appears large. Maybe new normal 30 year-rate is 4.5%, which would support Lars’ point.

    Reply
  6. Benjamin Cole

     /  September 12, 2013

    Well, I do disagree.

    There is still tons of unused capacity and unemployment in the USA. Why let it sit on the sidelines? The PCE deflator at 1 percent and trending down. There is no inflation to fear.

    I like prosperity, boom times Fat City. We are not there.

    Reply
  1. TheMoneyIllusion » Instant reaction: All hail Ben Bernanke!
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