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Positive Economic Commentary

The Fed: A Failure to Communicate Or Communicated Only Too Well?
August 01, 2003

Following the May 6 FOMC meeting, at which time the Fed made known its displeasure with further declines in the inflation rate, the yield on 10-year Treasury notes began to fall. On an intraday basis, the Treasury 10-year yield slid to 3.07% on June 16 its lowest level since 1958. Yesterday, July 31, the Treasury 10-year yield closed at a yield of about 4.45%. Why has the yield backed up so much since its recent low of June 16? Some commentators argue that yields have risen in recent weeks because the Fed has done a poor job of communicating. Although the Fed continues to say that it is concerned that inflation might fall further, it has failed to act accordingly. For example, the Fed cut its funds rate target by "only" 25 basis points to a level of 1% on June 25. In the view of some, if the Fed were really serious about preventing further declines in inflation, it would have cut the funds rate by at least 50 basis points on June 25. Moreover, Fed Chairman Greenspan, in recent congressional testimony, suggested that it would be unlikely that the Fed would have to resort to "unconventional" operating procedures, such as massive purchases of longer maturity Treasury securities, to accomplish the objective of precluding further declines in inflation. So, according to some, the recent rise in Treasury bond yields is because the Fed botched its communication to market participants. On May 6, the Fed indicated an all out attack on falling inflation, which allegedly created expectations of larger funds rate declines and massive Fed purchases of longer-maturity Treasury securities. Since then, however, it has failed to match words with deeds.

I, of course, have a different take on the reason for the recent backup in yields. I believe that the Fed communicated its intents only too well. In fact, the Fed's intent could not have been made clearer than on November 21, 2002, when Fed Governor Bernanke uttered the following words in a quite remarkable speech entitled "Deflation: Making sure 'It' Doesn't Happen Here":

Indeed, under a fiat (that is, paper) money system, a government (in practice, the central bank in cooperation with other agencies) should always be able to generate increased nominal spending and inflation, even when the short-term nominal interest rate is at zero.

U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a papermoney system, a determined government can always generate higher spending and hence positive inflation.

inflation in the past 200 years might have some bearing on this, as shown in Charts 1 and 2, below. Notice that U.S. consumer inflation was considerably lower prior to the inception of the Federal Reserve System in 1914. From 1800 through 1913, the compound annual change in the U.S. CPI was minus 0.45%. From 1914, when the Fed began operations, through 2002, the compound annual change in the CPI jumped up to plus 3.31%. Chart 2 shows that starting in 1801 through 1913, the median annual change in the U.S. CPI was a big fat goose egg zero. But from when the Fed opened shop, 1914, through 2002, the median annual change in the CPI has been 2.88%. Now, perhaps this secular rise in inflation and the creation of the Federal Reserve System is just some coincidence without any causality. I doubt it. I think that Governor Bernanke hit the inflation nail on the head with his observations about fiat money. As an aside, notice in Chart 1 how, prior to the creation of the Fed, the price level fell back to or below where it was prior to its wartime spikes of 1812-1814 and 1861-1865. This did not occur after World War I (1914-1919) or any other wars since the inception of the Fed. If expectations are at all affected by experience, then it would be reasonable to assume, based on the past 88 years of experience, that bond market investors should expect inflation to persist over the next 10 years, especially with the Fed explicitly saying that it will do its best to keep inflation "alive."

Chart 1

Chart 2

Another interesting "coincidence" is the tendency for yield curves to be upward sloping since the inception of the Fed, whereas, prior to this event, they were, more often than not, downward sloping. As shown in Chart 3, the median ratio of high-grade corporate bond yields to commercial paper interest rates was 0.87 in the years 1857 through 1913. Thus, prior to the inception of the Fed, there was a tendency for bond yields to be below, money market yields. With the creation of the Federal Reserve System in 1914 through 2002, the median of this ratio jumped by 52% to 1.32. That is, since the Fed came into existence, it has been more common for bond yields to be above money market yields. Of course, this change in relationships between bond yields and money market interest rates is not surprising given the change in the behavior of inflation. If inflation is the rule rather than the exception, then higher future interest rates would be more likely than not. Hence, a positively sloped yield curve would be the norm.

Chart 3

In sum, I believe that the recent rise in bond yields and the steepening in the yield curve have occurred because market participants have correctly interpreted the Fed's intentions. With federal government spending soaring and expected to do so even more in the decades ahead, with the U.S. being the world's largest net debtor nation and likely to continue being so in the decades ahead, and with the Fed explicitly saying that it wants higher inflation, is there any doubt, given the Fed's performance record since 1914, that higher inflation will occur in the U.S. over the next 10 years? And if higher inflation is expected, is there any doubt that bond yields could rise?

Note: I am indebted to James Bianco and the Leuthold Group for the data used in this commentary.

Paul Kasriel
Director of Economic Research

The information herein is based on sources which The Northern Trust Company believes to be reliable, but we cannot warrant its accuracy or completeness. Such information is subject to change and is not intended to influence your investment decisions.

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