Monday, 11 August 2008

US long term interest rates stay high

There is one reality that all central bankers must face. They can change short-term interest rates, but long rates belong to the market.

The Fed started aggressively cutting the Federal Fund rate earlier this year. However, the 10 year treasury bond rate has remained stubbornly high. Bond holders haven't paid much attention to the Fed's desperate attempts to stave off recession with headline grabbing rate cuts. Those 75 basis point cuts might look good on a press release but so far the cuts have left financial markets cold. As a result, many lending rates, such as mortgages and auto loans have hardly moved in the last six or so months.

The Bank of England would do well to study this experience. Any attempt to bring UK long rates down while inflation remains high is likely to fail. The yield curve will steepen as inflation expectations rise and feed into long term rates.

Central banks who push their policy rates into negative territory, typically lose control of long rates. Monetary policy starts to have perverse effects on the economy. Rapid monetary growth, which invariably accompanies negative rates, generates inflation. At the same time, long rates increase, leading to a slowdown in investment and economic growth.

The end result is stagflation.

2 comments:

CWS said...

Another classic chart.....

Edward Harrison said...

Alice, this chart is too good. It shows the conundrum Bernanke faces. Greenspan wondered why interest rates didn't respond as he raised them near the end of his term. Bernanke has to be wondering the same thing as well.

Obviously, the Fed has lost all control of long term rates and this is part of the reason their liquidity is not having the desired outcome.

And I reckon you are right -- the BoE would get the same result if it tried. But try they will.