Greenspan's conundrum ten years on

In 2005, the Federal Reserve (Fed) Chairman at the time, Alan Greenspan, described the behaviour of long-term interest rates during the tightening up of monetary policy that was underway as a «conundrum». The figures spoke for themselves: between June 2004 and July 2006 the Fed had raised the official interest rate by 4 pps to create more restrictive financial conditions and put a stop to the risk of the economy overheating. But 10-year Treasury yields increased by merely 0.3 pps, thereby neutralising one of the main mechanisms for cooling down the economy. The potential occurrence of this phenomenon, called «Greenspan's conundrum», has now resurfaced given the imminent start of interest rate normalisation in the US.

Conceptually, the long-term interest rate or LTR, for example 10 years, has three components. First, the real short-term rate expected by market participants as an average for the next ten years (RESTR). Second, the long-term inflation expectations, at 10 years, of these participants (LTIE). And third, the term risk premium (TRP) demanded to invest in bonds with long maturities rather than successively investing in short-term bonds. When the central bank modifies the official short-term rate (or announces its strategy and monetary policy plans), each of these three components is likely to move either upwards or downwards, obviously also depending on other forces or shocks. While the Fed was tightening up its monetary policy in 1988, 1994 and 1999, the LTR rose noticeably, pushed up both by the RESTR (because market participants took the Fed's message on board that it was willing and able to maintain a higher level for the short-term rate) as well as the TRP (given the greater uncertainty regarding the level and volatility of short-term rates in the near future). The LTIE component would have moved downwards (as the Fed was committed to combating inflation) but with less impact due to the anchoring of expectations since credible inflation targets had been set.

The phase of tougher monetary policy in 2004 put a stop to these earlier trends. In spite of rapid rises in the official rate, the LTR hardly moved at all. Several studies have shown that the component that evolved differently compared with previous cycles was the TRP, on that occasion falling noticeably (by around 1 pps), counteracting the rise, as per the script, experienced by the RESTR (while the LTIE remained stable). Greenspan's conundrum therefore lay in the term premium, a variable whose importance grows when market imperfections intensify (the limits to arbitrage between maturities). The fundamental forces leading to this drop in the term premium are now well-known: excessive global savings, the accumulation of reserves by the central banks of many countries, a search for safe assets and, as a result, strong demand for long-term US Treasury bonds which was not passed on to shorter terms.

Ten years later, a large proportion of these structural factors are still in place, suggesting that they would tend to offset the upward pressure on the LTR exercised by the forces of the economic-monetary cycle. The gradual fall in the rate of potential growth of the US economy, the persistence of abundant savings worldwide, the demographics and ageing populations in advanced countries and the fact that few assets are considered as safe will continue to limit the extent of any rises in the LTR via downward pressure on the RESTR and TRP. The expectations of Treasury market participants seem to be along these lines, judging by the scenario implicit in the current rate curve, according to which the LTR will rise very little over the coming years in spite of the Fed's actions and the debt curve will flatten out considerably. However, this market view of the LTR trend omits two key elements. Firstly, bond investors have very low LTIE today and this perception could have an abrupt effect should price or wage indicators be surprisingly high, leading to sharp upswings in the LTR. Secondly, the Fed's willingness to sell the 4 trillion dollars of bonds in its portfolio, a circumstance that could notably push up the TRP. In this respect leading Fed members have warned on several occasions that the institution will adopt a more aggressive normalisation strategy if the LTR does not move upwards. In other words, we are unlikely to witness a «Yellen's conundrum» in the future.