yield curve

Might the Fed cap long-dated Treasury yields? This suggestion, made by Bernanke himself in 2002, has resurfaced in the blogosphere amid rising fears of deflation.

In recent days, the Washington Post’s Neil Irwin and the New York Times’ Paul Krugman have both asked what the Fed can usefully do if there is another slowdown. The meticulous Bill McBride, the man behind Calculated Risk blog, offers an insight into Bernanke’s ‘roadmap’. The speech might be old, but the thinking seems more relevant than ever.

Over to Bernanke:

So what then might the Fed do if its target interest rate, the overnight federal funds rate, fell to zero? One relatively straightforward extension of current procedures would be to try to stimulate spending by lowering rates further out along the Treasury term structure–that is, rates on government bonds of longer maturities.

There are at least two ways of bringing down longer-term rates, which are complementary and could be employed separately or in combination.

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The Greek central bank would pay a lower interest rate on 30-year debt than on 10-year debt, if issued today. Usually, longer-term debt commands higher interest rates, as investors want compensation for the additional risk of holding the debt for longer.

Demand for shorter-dated debt provides an explanation. The shorter-dated end of the curve (left hand side) has moved up far more than the longer-term end (right hand side).

Most outstanding Greek debt is due to expire (and need refinancing) within the next ten years (see left).

In 2009, this partly negative yield curve was rare. So far this year, it has been more common. The most inverted curve occurred around February 8, when an IMF bail-out was mooted. Yields since then have dropped for all terms, only to rise again – extremely sharply, and to record levels – since Easter. Although a bail-out plan has been agreed in principle between the EU and IMF, there is disagreement over how much Athens should pay for help. Most nations agree on a rate of 4-4.5 per cent for debt, but Germany says market rates are appropriate. Read more