In February 2005, then Fed Chairman Alan Greenspan referred to the decline in long-term rates in the wake of the Fed increasing the target for the federal funds rate by 150 basis points as a "conundrum" St Louis Fed's Daniel L. Thornton has investigated Greenspan's remarks and provides an answer, in a new working paper: The unusual behavior of the federal funds and 10-year Treasury rates: a conundrum or Goodhart's Law?
I show that the relationship between the 10 year Treasury yield and the federal funds rate changed dramatically in the late 1980s, well in advance of Greenspan's observation. I argue that the marked change in the relationship between the federal funds rate and long-term yields is a natural consequence of Goodhart's Law.
Here is what happened:
Once the Fed began targeting the funds rate for policy purposes and the funds rate remained close to the target, the behavior of the funds rate is necessarily different from what it would have been had it been free to respond to market fundamentals. This implies that the relationship between the funds rate and rates that are less closely linked to the funds rate would necessarily change. Since long-term yields are much less affected by the funds rate than other shorter-term rates, it is reasonable that the relationship between the funds rate and long-term rates would be most affected.
This hypothesis is supported by the fact that there was a marked change in the relationship between changes in the 10-year Treasury bond yield and changes in the federal funds rate that occurred in the late 1980s. The change in the relationship is statistically significant at monthly and quarterly frequencies. Moreover, an analysis of the levels of these rates indicates that the change persists at lower frequencies as well.
Some of you may not have heard of Goodhart's Law. It was coined by British economist Charles Goodhart in the mid-1970s, when he was was Chief Adviser to the Bank of England. The basic idea is that when a government attempts to regulate any particular set of financial assets, these become unreliable as indicators of economic trends. This proved prophetic when Margaret Thatcher was elected Prime Minister in 1979, and sought - disastrously - to conduct monetary policy on the broad and narrow money supply targets.
Almost as soon as this post went up, another paper on the same subject appeared. Cracking the Conundrum, by the Stern School's David Backus and Federal Reserve economist Jonathan H. Wright, has just been published as Finance and Economics Discussion Series No. 2007-46. The authors hedge their best a little more than Thornton, citing several possible contributing factors:
From 2004 to 2006, the FOMC raised the target federal funds rate by 4.25 percentage points, yet long-maturity yields and forward rates fell. We consider several possible explanations for this "conundrum." The most likely, in our view, is a fall in the term premium, probably associated with some combination of diminished macroeconomic uncertainty and financial market volatility, more predictable monetary policy, and the state of the business cycle.
I accept there was a decline in the term premium (the expected return on long-term bonds). But surely this begs the obvious question: 'why?'. A post by James Hamilton of Econbrowser fame provides some discussion: The term premium and reduced volatility