On Friday I attended a conference at the Federal Reserve Bank of San Francisco, which included a very interesting presentation by Fed Chairman Ben Bernanke on long-term interest rates.
The Chairman began by noting that, with the exception of Japan, the nominal yields on 10-year bonds in many of the major economies have moved together quite closely over the last decade. The data below are quite persuasive– one should not attribute the recent very low yields in the United States to policies or developments that are unique to our country.
Using a model of bond yields
developed by Federal Reserve staff, Bernanke showed how the movements in the U.S. nominal 10-year rate might be broken down into three separate components: market expectations of future inflation (blue triangles in the graph below), expectations of future short-term real interest rates (black circles), and a residual referred to as the term premium on 10-year bonds (green crosses). The contribution of the first of these (expected inflation, in blue) has been reasonably steady around the Fed’s long-run goal of a 2% inflation rate.
By contrast, expectations of future short-term real interest rates (black line) have fallen significantly since 2006. Bernanke noted that this, too, has been the experience in other major economies, and offered this interpretation:
Real interest rates are expected to remain low, reflecting the weakness of the recovery in advanced economies (and possibly some downgrading of longer-term growth prospects as well). This weakness, all else being equal, dictates that monetary policy must remain accommodative if it is to support the recovery and reduce disinflationary risks.
The term premium (green in the above figure) has also been declining. Bernanke attributed this to the lower levels of yields themselves (which makes near-term short rates easier to forecast), a flight to safety supporting demand for U.S. Treasury debt, and the Fed’s large-scale asset purchases.
The Chairman also noted that as economic conditions improve, expected future real yields and the term premium would be expected to return toward more normal levels:
If, as the FOMC anticipates, the economic recovery continues at a moderate pace, with unemployment slowly declining and inflation expectations remaining near 2 percent, then long-term interest rates would be expected to rise gradually toward more normal levels over the next several years. This rise would occur as the market’s view of the expected date at which the Federal Reserve will begin the removal of policy accommodation draws nearer and then as accommodation is removed. Some normalization of the term premium might also contribute to a rise in long-term rates.
Bernanke called attention to several different forecasts of where the 10-year yield might be a few years down the road, including the Blue Chip consensus, Survey of Professional Forecasters, CBO, and the term-structure model that was used to construct Figure 1 above.
I was quite surprised to see the Fed Chairman produce this graph. If it is indeed the case that the 10-year yield is going to rise from 2% to 4% relatively quickly, it would mean significant capital losses for someone who buys a 10-year bond today. If the market comes around to taking such forecasts more seriously, bond prices should fall on Monday.
However, Bernanke also emphasized that there is considerable uncertainty associated with these forecasts, on the down side as well as the up side.
Bernanke offered the following explanation for why he wanted to call attention to forecasts of future ten-year rates:
It is worth pausing to note that, not that long ago, central bankers would have carefully avoided this topic. However, it is now a bedrock principle of central banking that transparency about the likely path of policy, in general, and interest rates, in particular, can increase the effectiveness of policy. In the present context, I would add that transparency may mitigate risks emanating from unexpected rate movements.
Bernanke is clearly committed to keeping short-term interest rates low for quite a while yet. But a separate question is how much more the Fed wants to allow its balance sheet to grow with additional large-scale asset purchases. I think they’ll want to give ample warning in advance of actually stopping the new purchases.
And perhaps before dropping more direct hints about ending LSAP, Bernanke would want to make a speech like this one.
UPDATE at 10:42 PST March 3: The original version of this post made an error in calculating the size of the prospective capital loss on long-term bonds, which has been deleted from the current version.