Summary: what is a main concept in the case or article? Situations that arise in the case or article. Possible solutions to such situations (applying the lesson of the day). Select one possible solution to the case. Explanation for how you select this solution (the best alternative is not always feasible to resolve the central or primary situation presented in the case or article). Reflexive analysis on developments in the case or article. You can use other references that approach the situation raised in this case or article from other perspectives. Conclusion or recommendation. If the case has questions, answer them. Analyses article Haubrich, J. G. (2004). Interest rates, yield curves, and the monetary regime. Federal Reserve Bank of Cleveland. Economic Commentary, , 1. ECONOMIC June 2004 COMMENTARY Federal Reserve Bank of Cleveland Interest Rates, Yield Curves, and the Monetary Regime by Joseph G. Haubrich Talk to just about any Federal have nothing of the kind. This Eco- Reserve economist, and they will tell nomic Commentary looks at how such you that at cocktail parties, school arrangements influence the impact of The yield curve has a wealth of fundraisers, and whatnot, the question Federal Reserve actions on the broader information about future interest they always get asked is "where are financial markets. In a phrase, it looks rates and economic conditions. interest rates going?" Now while the at the impact of monetary regimes.' Users should exercise caution Fed economist may have little wisdom though, as many of the rela- Regimes to impart. it is true that the Federal tionships that hold between the Reserve does target interest rates Probably the best way to think of a behavior of the curve and what it The rate that the Fed targets, how- monetary regime is as a set of institu fortells depend on the monetary tional arrangements- how monetary ever, the federal funds rate, is of direct regime in place at the time the interest only to bankers and other policy is set up along with the cor curve is drawn. responding expectations of the pub- investment professionals (who seem over-represented in certain Cub Scout lic. Thus it's not just what is called the packs, but that's another story). The monetary standard, which comprises the laws, regulations, and bureaucracy rates people worry about are the ones that more directly affect them mort- governing the money supply, but also Of course, some inflation is still pos includes expectations--does the public gages, auto loans. credit cards. sible in the short run because trans- believe the commitment to zero infla port costs, shipping delays, and so on Of course. the Federal Reserve does tion. or not? mean that money isn't immediately affect these interest rates. but the con The concept of a monetary regime is converted into gold, but barring major nection between the short-term rate gold discoveries, the inflation will dis- targeted by the Fed and the longer- quite broad. The situations encom- passed range from systems where sipate quickly. term rates most people worry about is complicated and involves some subtle money consists of unbacked, rather A fiat regime has no backing for factors. It's generally understood that flimsy pieces of paper to those where money. That is, the government or when the Fed changes the federal people knew the money supply would central bank will only exchange your funds rate, other rates in the econ- change only if someone sailed to a dis- paper money for other paper money. tant island and returned with disk hewn omy also change. What's less appre- not gold or silver. (The word fiat ciated is that the way interest rates from solid rock (as was the case on the comes from the Latin for "let it be change depends not just on what the Isle of Yap). Usually though. monetary done." indicating that the government regimes tend to be a variation of two Fed does today. or even next month just declares that the paper is money.) or next year, but also on people's per- (somewhat idealized) types: commod ceptions about the goals and credibil ity standards and fiat systems A gold standard is not the only regime ity of the monetary authority. These that will keep inflation low. A fiat Commodity standards presuppose that goals and the accompanying expecta- regime. where money is not backed. money is freely convertible into a com- tions in turn depend on the institutional can still be credible if there is a com- modity-usually gold. but silver is also arrangements of monetary policy mitment to low inflation. This commit common. Under a gold standard, for some countries have laws mandating ment might be informal, just a consen- example, the money supply is fixed by sus of those in charge, or the product low inflation, others have a tradition the supply of gold in the world. This of keeping inflation low, still others of culture and tradition. The commit- provides a nominal anchor to the price ment to low inflation might be man- level, effectively preventing long-term inflation since it ties money to gold. ISSN 0-428-1276 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.dated by law, as in Canada, Great Brit- requirement was eliminated in 1968. buy less than dollars today, so get- FIGURE 1 INFLATION IN THE UNITED STATES long-term rates along with short-term ain, and New Zealand. Just as in the After this time, foreign central banks ting 10 percent interest does not buy rates. That is, yields shift up together gold standard case, sometimes inflation could still exchange dollars for gold. you 10 percent more stuff. The "real" Percent all along the curve, keeping the slope will occur, but the central bank acts to but even this ended in August of 1971. return or real yield is less than 10 per 10 roughly constant. That means persistent bring it down. And people expect that cent because of the value inflation inflation does little to change the slope to happen. At least since 1972. the United States 30 takes away. Smart investors know this. of the yield curve, keeping its predictive has been on a fiat regime. This has at and take account of expected inflation properties intact. So under a noncred- Regimes are not always credible. imes looked like both the credible and when making financial transactions. As 20 ible regime the yield curve does better For example. when the price level and the noncredible fiat regime described in forecasting the real economy money supply are not tied down by law a result (the famous Fisher equation) above. For most of the 1970s, inflation the nominal interest rate on a bond or 10 or by a gold standard, inflation can. was high and it persisted at high levels money market account can be thought The differences in credibility perhaps and has. gotten out of control. Thus. for most of the decade. Since the mid- of as being composed of a real rate and underlie the somewhat murky perfor- the economy may see, in addition to dle 1980s, however, inflation has been an expected inflation rate. A 10 percent mance of the yield curve in predict- short-term inflation, inflation over the lower. and its increases only temporary. longer term. People realize that infla- interest rate with no inflation gives you -10 ing the most recent recessions. In the the same real return as a 15 percent carly 1980s. when the credibility of the tion has increased and is unlikely to Riding the Yield Curve interest rate when inflation runs at Federal Reserve was not as strong, the -20 decrease for quite some time. Neither The different types of monetary percent. yield curve gave clear signals of reces- he workings of a gold standard or the regimes embody different patterns of sions. The recession starting in Janu- -30 commitment of the central bank are in action by the central bank and different This is where regimes, their credibility. ary 1980 was heralded by an inverted place to force inflation back down. expectations of the public. These pat- and the persistence of inflation come 1860 1880 1900 1920 1940 1960 1980 2000 yield curve a year earlier. in January erns strongly color how interest rates in. Under a credible regime. such as a of 1979, and short rates exceeded long In some sense, then, a good measure of will move. Understanding the influ- gold standard. inflation may be high at SOURCES: Balke and Gordon (1986); and the U.S. Department of Commerce, Bureau of rates by almost a full point by Septem- the credibility of a regime is the per- ence of these patterns means taking a omic Analysis. times, but it is only temporary. Thus, ber of 1979. Similarly. the recession of sistence of inflation. In both the gold closer look at different interest rates. shorter-term rates three months, one July 1981 was preceded by an inverted standard and the credible fiat regime. year. and so forth, should build in that yield curve, where short rates exceeded a burst of inflation does not last, as As mentioned above. there are many inflation premium, and increase. Over case. It's even possible that people see ing, they embody the expectations of long rates by over two and half percent either the standard or the central bank ypes of interest rates in the finan- the long haul, however, inflation will a small rise in inflation today and think a great many people, and thus contain in December 1980.' soon gets prices under control. With cial marketplace: Think of mortgages. revert to low levels. so there shouldn't this presages even more inflation, so a lot of information about the future. a noncredible fiat regime, however. savings bonds, auto loans, and junk be much of an inflation premium on the curve gets steeper. Many people in fact use the slope n contrast. when the Federal Reserve things are different. Higher infla- bonds. There are interest rates on safe 10-, 20-, or 30-year bonds. of the yield curve- the difference had attained greater credibility. predic tion may last for a long time. What investments (savings bonds) and risky Digging in the Data between long and short rates- -to fore- tions from the yield curve were not so was temporary inflation in a credible investments (junk bonds). short-term This means that under a credible Now all this matters precisely because cast economic growth. The idea is that clear. Prior to the 1990 recession. for regime becomes persistent inflation in rates and long-term rates, rates backed regime, inflation shocks end up flatten- many people are anxious to extract any in inverted yield curve can signal an example. the yield curve did not invert. a less credible regime. by hard collateral (auto loans), and ing the yield curve temporarily. (Con- information they can from the yield upcoming recession. More generally, a though it did flatten considerably. Prior those backed by promises to pay. Fo versely. a shot of deflation will make curve. So the first set of people who can flat (or inverted) yield curve presages to the most recent recession starting As the reader might have guessed. our purposes. though. the most impor the curve steeper.) benefit from understanding the relation vth, with a steep curve pre- in March 2001. the curve did invert, these regimes are not purely imaginary. tant patterns arise when we concentrate between regimes and the yield curve are dicting faster economic growth. The but short rates exceeded long rates by though they may be starker than what on different maturities: short versus Things are different under a less cred- those financial analysts. market watch- easons for this are not entirely clear barely half a percentage point. and that is actually seen in practice. The United long rates. And to avoid differences in ible regime, where inflation is more ers, and homeowners looking to refi- but in part, this may reflect monetary was in December of 2000, giving little States was on some form of a gold isk and so forth. it makes sense to fur- persistent. Inflation hangs around lon- nance who are concerned with the rela- policy: A steep yield curve means the lead time. standard from 1879 until 1933. For ther focus on just U.S. Treasury debt, tionship between long and short rates. central bank is keeping short- most of that period inflation remained which is considered default free. Plot high inflation tomorrow as well. The rates below average, indicating expan- Clouds and Silver Linings low (see figure 1). The major excep ting these rates against their maturity inflation premium not only gets built The lesson for them is that the regime sionary policy. How reliable this yick The points made about regimes, infla- tion was World War I and its aftermath. produces the yield curve. Understand n to short rates, but to longer rates as matters a lot when thinking about the curve signal is varies over time, how- tion, and yield curves have neglected when inflation at times reached nearly ing how the yield curve moves and well. Unlike the credible case, where connection between long rates and ever, and the reliability depends a lot some very important issues. There are 30 percent. This reflected massive gold reacts to different economic events pro- inflation moved up only short-term short rates. Seeing short rates rise on which monetary regime we're in large advantages to having a regime imports from Europeans looking for vides a glimpse into the relationships interest rates. in the noncredible case. today doesn't always tell you much with stable low inflation. Firms and a safe harbor for their assets. Shortly between long- and short-term interes nflation moves up long and short about long rates, and this is particu- Recall that under a credible nomina workers can set contracts without wor after the war, though, as the European rates. For example, short-term inter- rates. This shifts the entire yield curve larly true in times of low and stable regime, with a gold standard or infla rying about inflation cating away the countries returned to the gold standard. st rates might be quite low, but that up. The curve does not, however, get inflation. For example, over the past tion target, inflation, being temporary, gains. The tax code won't automati- prices fell, and it was deflation that hit does not guarantee low long-term rates appreciably steeper or flatter, as rates decade and a half, 10-year interest will increase short rates but leave long cally bump people into higher tax double digits in the United States dur- A steeply sloped yield curve will have move up with inflation. rates have shown both large increases rates unchanged. Bursts of inflation brackets even if real incomes don't ing the early 1920s. ong rates much higher than short rates and decreases in response to changes then add noise to the signal the yield rise. The post office won't have to keep That last point deserves a bit more in the federal funds rate, the overnight curve is giving- . some purely nomi- raising the cost of stamps. After 1933, when Americans could no What does this talk of interest rates explanation. Whether the curve gets rate targeted by the Fed's Federal Open nal shifts are added to the movements longer exchange their dollars for gold have to do with regimes? The mon- steeper or flatter depends on how per- Market Committee forecasting the real economy. Under a But these advantages come with some (or even own gold), the United States ctary regime has a lot to do with the sistent inflation is. In one extreme case. credible regime, then, the yield curve costs, and one of these costs is a yield still retained a tenuous link to the gold shape and movement of the yield where higher inflation today causes Another set of people who should heed should have some trouble forecasting curve that is more difficult to interpret standard in that currency was required curve, and thus with how closely short- people to expect that higher rate for the message about regimes are those Such a cost hardly justifies a return to have a partial gold backing. The and long-term rates move together (or ever, the slope does not change. If' who use the yield curve to help fore- the real economy. to double-digit inflation. but it should government was required to hold a cer inflation is less persistent, the long cast the future. This probably includes With a regime that is not credible. serve as a cautionary reminder that tain amount of gold for each Federal rates won't rise as much as short rates. many of those responsible for mon- he situation is different. Since infla- some signals and indicators will prove Reserve note issued to the public. This The first step in this process is recall- and the curve will move up and flatten, ctary policy. Because financial markets tion is more persistent, it tends to hang murkier in some regimes than others. ng how inflation affects interest rates though not as much as in the credible are by their very nature forward look- around for a while, and this drives up When prices rise, dollars in the future Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission