May 26, 2006
THE CONUNDRUM CONUNDRUM
In order to know what is going to happen, one must know what has happened.
The "conundrum" of low bond yields in the face of rising inflation and a robust economy may be yesterday's news, but a consensus on the causes remains elusive. Indeed, one of the more common explanations--foreign central bank buying, particularly from those in Asia--wasn't the cause after all, according to a new research paper by economists at two Fed banks, which we'll get to in a minute.
But first, it's worth noting that the ignorance could be a problem for monetary policy in the future. If the forces behind the conundrum aren't understood, those forces may yet come back to bite Bernanke's Fed. How can you manage something you don't understand? The answer, of course, is that you can't. And if you can't understand the forces affecting monetary policy, the risks are higher that your policy could run amuck and dispense effects into the economy that are unnecessary or even dangerous in the pursuit of a stable and low-inflation, a stable currency, and so on.
It's hardly comforting to know that former Fed head Alan Greenspan chose the word "conundrum" to describe the capacity for long yields to stay low when the central bank tried to engineer a higher price of money. The idea that a mysterious but powerful force is rewriting market rules for the global economy should give both investors and central bankers pause.
What you don’t know can hurt you when it comes to deploying monetary policy. That starts with allowing inflationary forces to take root when one might suppose otherwise. Another skulking threat might be the nurturing of speculative bubbles when the Fed intends nothing of the kind.
There is no shortage of opinions about why long rates--which are set by the marketplace--stayed so low for so long, much to the Fed's consternation. Fed Chairman Bernanke, before he reached his current exalted position, opined as a Fed governor that a "global savings glut" was the source of the conundrum. A more ambitious explanation came from Christopher Probyn, chief economist for SsgA, who last year wrote that the low yields were a byproduct of a "confluence of forces, including the transparency of monetary policy, contained inflationary expectations, pension reform, foreign central bank demand for U.S. securities, a new government deficit financing strategy, and the shift to floating rate debt." Perhaps he should have simply blamed the global economy.
But is it really that simple (or complicated)? Not necessarily. Consider a more modest analysis of what's going on, which comes by way of a new research paper penned by economists at the San Francisco and Dallas Fed banks. In fact,
The Bond Yield Conundrum from a Macro-Finance Perspective is notable for what it doesn't find: easy explanations.
Although the paper's models document that the low yields of 2004 and 2005 were "unusual," the variable showing the most explanatory relevance, albeit a small one, "is declines in the (short-run implied) volatility of long-term Treasury yields…. Even so, at best, almost two-thirds of the conundrum remains unexplained."
The most-provocative part of the paper's conclusions is what it didn’t find, namely, that foreign central bank buying of Treasuries explains the abnormal persistence of low yields in 2004 and 2005. "Large-scale purchases of long-term Treasuries by foreign central
banks," the authors write, "has essentially no explanatory power for the conundrum episode."
The paper concludes by putting a positive spin on the mystery. "The resolution of these "conundrum" episodes, in the U.S. and abroad, presents a rich frontier for future research." Somehow, we suspect that Bernanke and company will have a slightly different reaction.
Posted by jp at May 26, 2006 12:41 PM
From the Fed paper:
"Finally, we proxy for foreign government and foreign central bank purchases of U.S. Treasury securities by using the 12-month change in the custodial holdings by the New York Fed for all foreign official institutions"
As Brad Setser frequently argues (or, via Brad S, see Martin Feldstein here, page 7), official data on foreign CB holdings is likely inaccurate and badly understated. Flawed data may all we have right now, but however marvellous the methodology, models based on that data can hardly be conclusive. Unfortunately, without more reliable data, it may be impossible to test whether central bank inflows have restrained US long rates.
(Note the graph on p. 39 of the Fed paper, showing a plummeting of foreign CB inflows since 2004. This is simply implausible, as the US trade deficit has grown over this period, oil prices have skyrocketed, while China and many oil producers remain largely pegged to the USD. It is more likely that as inflows have become more controversial, official buyers have become more discreet.)
Posted by: Steve Waldman at May 26, 2006 7:30 PM