When US 30-year yields hit 5% the Great Recession will be over

US bond yields are spiking today. You might expect me to celebrate it and say this is great (while everybody else are freaking out…) Well, you are right – it doesn’t worry me the least bit.

That said, the US story is not necessarily the same story as the Japanese story. Hence, while Japanese real yields actually have declined sharply US real yields continue to rise as break-even inflation in the US has actually declined recently – most likely on the back of a positive supply shock due to lower commodity prices.

But obviously higher real yields should only be a worry if it is out sync with the development in the economy – as in 2008-9 when real yields and rates spiked, while at the same time the economy collapsed. However, if the economy is in recovery it is only naturally that real yields and rates start to rise as the recovery matures as it certainly seems to be the case in the US.

Anyway, this is not really what I wanted to discuss. Instead I was reminded about something Greenspan said in 1992:

“Let me put it to you this way. If you ask whether we are confirming our view to contain the success that we’ve had to date on inflation, the answer is “yes.” I think that policy is implicit among the members of this Committee, and the specific instruments that we may be using or not using are really a quite secondary question. As I read it, there is no debate within this Committee to abandon our view that a non-inflationary environment is best for this country over the longer term. Everything else, once we’ve said that, becomes technical questions. I would say in that context that on the basis of the studies, we have seen that to drive nominal GDP, let’s assume at 4-1/2 percent, in our old philosophy we would have said that [requires] a 4-1/2 percent growth in M2. In today’s analysis, we would say it’s significantly less than that. I’m basically arguing that we are really in a sense using [unintelligible] a nominal GDP goal of which the money supply relationships are technical mechanisms to achieve that. And I don’t see any change in our view…and we will know they are convinced (about “price stability”) when we see the 30-year Treasury at 5-1/2 percent.

Yes, that is correct. 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.

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Josh Hendrickson shows that the Fed targeted NGDP growth

I have previously quoted Alan Greenspan for saying the following at a FOMC meeting in 1992:

“Let me put it to you this way. If you ask whether we are confirming our view to contain the success that we’ve had to date on inflation, the answer is “yes.” I think that policy is implicit among the members of this Committee, and the specific instruments that we may be using or not using are really a quite secondary question. As I read it, there is no debate within this Committee to abandon our view that a non-inflationary environment is best for this country over the longer term. Everything else, once we’ve said that, becomes technical questions. I would say in that context that on the basis of the studies, we have seen that to drive nominal GDP, let’s assume at 4-1/2 percent, in our old philosophy we would have said that [requires] a 4-1/2 percent growth in M2. In today’s analysis, we would say it’s significantly less than that. I’m basically arguing that we are really in a sense using [unintelligible] a nominal GDP goal of which the money supply relationships are technical mechanisms to achieve that. And I don’t see any change in our view…and we will know they are convinced (about “price stability”) when we see the 30-year Treasury at 5-1/2 percent.

Now Josh Hendrickson has a new paper out – “An Overhaul of Federal Reserve Doctrine: Nominal Income and the Great Moderation” – that basically confirms that the Fed actually did what Greenspan said it would do – at least during the Great Moderation. Here is the abstract:

“The Great Moderation is often characterized by the decline in the variability of output and inflation from earlier periods. While a multitude of explanations for the Great Moderation exist, notable research has focused on the role of monetary policy. Specifically, early evidence suggested that this increased stability is the result of monetary policy that responded much more strongly to realized inflation. Recent evidence casts doubt on this change in monetary policy. An alternative hypothesis is that the change in monetary policy was the result of a change in doctrine; specifically the rejection of the view that inflation was largely a cost-push phenomenon. As a result, this alternative hypothesis suggests that the change in monetary policy beginning in 1979 is reflected in the Federal Reserve’s response to expectations of nominal income growth rather than realized inflation as previously argued. I provide evidence for this hypothesis by estimating the parameters of a monetary policy rule in which policy adjusts to forecasts of nominal GDP for the pre- and post-Volcker eras. Finally, I embed the rule in two dynamic stochastic general equilibrium models with gradual price adjustment to determine whether the overhaul of doctrine can explain the reduction in the volatility of inflation and the output gap.”

Josh has written and excellent paper and I recommend everybody to have a look at Josh’s paper – maybe if we are lucky Ben Bernanke might also read the paper. After all the paper will be published in Journal of Macroeconomics. Bernanke is on the editorial board of JoM.

PS Josh also has a comment on this on his blog.

Update: Scott Sumner also has a comment on Josh’s paper.

There never was a bond market “conundrum”

Here is Alan Greenspan in Testimony February 16 2005:

“Long-term interest rates have trended lower in recent months even as the Federal Reserve has raised the level of the target federal funds rate by 150 basis points. This development contrasts with most experience, which suggests that, other things being equal, increasing short- term interest rates are normally accompanied by a rise in longer-term yields… For the moment, the broadly unanticipated behavior of world bond markets remains a conundrum.”

Back in 2005 there was lot of talk that bond yields was “too low” and Greenspan certainly contributed to the discussion of this “conundrum”.

Do you know what? There was really no conundrum. Today, seven years later we can actually see that long-term bond yields were too high rather than too low. How do I know that? Well, a (overly?) simplified calculation will show that. In 2005 5y and 10y bond yields were around 4%. Basically a 5 or 10-year bond is actually a collection of shorter-term bonds – for example 5 or 10 1y bonds.

So what have the average yield on 1-year US bonds been since 2005 until today? 2.5%! This is well below 4% that 5 and 10-year bonds were yielding in 2005.

Had Alan Greenspan been a Market Monetarist he might have said 2005 that “We have increased interest rates by 150bp in recent months and as a result inflation expectations are well-contained and as a result long-term bond yields are just around 4%. In fact as we are targeting a 5% growth path for the nominal GDP level there is a chance that we have overdone the tightening.”

Greenspan instead questioned the market’s judgement. The market was too optimistic on US NGDP growth, but not as extremely optimistic as Greenspan.

Believe it or not the market (at the least the bond market) was really forecasting quite a sharp slowdown in NGDP growth. So who says the market isn’t efficient?

Guess what Greenspan said on November 17 1992

This is then Federal Reserve chairman Alan Greenspan at the meeting of the Federal Open Market Committee on November 1992:

“Let me put it to you this way. If you ask whether we are confirming our view to contain the success that we’ve had to date on inflation, the answer is “yes.” I think that policy is implicit among the members of this Committee, and the specific instruments that we may be using or not using are really a quite secondary question. As I read it, there is no debate within this Committee to abandon our view that a non-inflationary environment is best for this country over the longer term. Everything else, once we’ve said that, becomes technical questions. I would say in that context that on the basis of the studies, we have seen that to drive nominal GDP, let’s assume at 4-1/2 percent, in our old philosophy we would have said that [requires] a 4-1/2 percent growth in M2. In today’s analysis, we would say it’s significantly less than that. I’m basically arguing that we are really in a sense using [unintelligible] a nominal GDP goal of which the money supply relationships are technical mechanisms to achieve that. And I don’t see any change in our view…and we will know they are convinced (about “price stability”) when we see the 30-year Treasury at 5-1/2 percent.

So in 1992 the chairman of the Federal Reserve was targeting 4.5% NGDP growth and 30-years yields at 5.5% and calling it “price stability”. Imagine Ben Bernanke would announce tomorrow that he would conduct open market operations until he achieved the exact same target(s)?

PS I got this from Robert Hetzel’s great book on the history of the Fed “Monetary Policy of the Federal Reserve – A History”.

 


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