Miscommunication Shook Up Mortgage, Bond Markets

Federal Reserve Bank of St. Louis - Regional Economist, Apr 2004 by Neely, Christopher J

WHAT THE FED SAID / WHAT THE MARKETS HEARD

Mortgage interest rates dipped to record lows early last summer, providing homeowners with a refinancing bonanza.

This decline in mortgage interest rates mirrored a fall in the 10-year Treasury bond yield (the interest rate on the bond), as shown in the left panel of Figure 1. In fact-as shown in the right panel of Figure 1-mortgage interest rates almost always mirror the yields on long-term Treasury bonds because they respond to the same forces. What factors drove the sharp declines in yields on 10-year Treasury bonds in the spring of 2003? Was the Federal Reserve responsible for the volatility, as some in the financial press have alleged? And why are mortgage interest rates closely linked to these Treasury yields in the first place?

Last Summer's Bond Market

The left panel of Figure 2 shows that in May and June 2003, yields of U.S. 10-year Treasury notes plummeted before rising sharply in July and August.1 The same panel shows that the yield on this 10-year Treasury note fell from 3.97 percent on April 14, 2003, to about 3.01 percent on June 13, 2003, then rebounded sharply to a high of 4.53 percent on Sept. 2, 2003.2

The roots of the sharp swings in the bond market turmoil lay in concerns about deflation-a sustained fall in the general price level-generated by steady declines in core U.S. inflation rates that began in 2001. Such a decline in the inflation rate is disinflation. By the fall of 2002, the declines had reduced U.S. inflation to levels consistent with price stability.3 That is, inflation was no longer a consideration in people's economic decisions. In fact, inflation had declined so much that the Federal Reserve began to consider further declines to be unwelcome because they might lead to deflation.

Overinflated Deflation Fears

Deflation is unwelcome for several reasons. First, a sustained fall in the price level is incompatible with the Federal Reserve's commitment to price stability. Second, some feared that the Fed's usual monetary policy instrument-changes in the federal funds target-would be useless in a deflationary environment because of the zero nominal interest rate bound. The zero nominal interest rate bound simply means that interest rates cannot be negative because lenders would not pay to lend money when they can simply hold cash. If prices are falling, then the real interest rate (the nominal interest rate less the rate of inflation) must be at least as great as the rate of deflation. And the real interest rate is a much better barometer of the stimulative impart of monetary policy than the nominal interest rate. For example, if prices are expected to fall at a rate of 2 percent per year and the Federal Reserve sets nominal interest rates at their lowest possible level (0 percent), then the real interest rate is still 2 percent, a fairly high level if economic conditions arc weak.

The zero nominal bound creates the incorrect perception that the Federal Reserve would be impotent in the face of deflation. Japan's economic problems over the past decade have contributed to this view. Since 1999, the Bank of Japan has seemed unable to stimulate the Japanese economy with conventional monetary policy and has seen very sluggish growth, coupled with some deflation. Some observers have worried that these problems might afflict the U.S. economy.

In November 2002, Federal Reserve Gov. Ben Bemanke gave a speech addressing the potential problem of deflation in the United States: "Deflation: Making Sure 'It' Doesn't Happen Here." Bernanke considered the chance of significant deflation in the United States to be "extremely small," but could not discount it entirely. To dispel the notion that the Fed would be helpless in the face of deflation, however, Bernanke reviewed some policy steps that the Fed could take to stimulate the economy if deflation did occur in the United States.4 The primary measure would be to buy longer-term bonds than the Fed usually buys (one year or less) in conducting open market operations, lowering long-term yields as well as short-term yields. In this manner, the Fed could pump liquidity into the economy, stimulating spending, raising prices and ending (or preventing) deflation.

The trigger for the bond market turmoil was Fed Chairman Alan Greenspan's follow-up April 30, 2003, to the semiannual monetary policy report to Congress. In that report, Greenspan said:

As you know, core prices by many measures have increased very slowly over the lust- six months. With price inflation already at a low level, substantial further disinflation would be an unwelcome development, especially to the extent it put pressure on profit margins and impeded the revival of business spending.

And the FOMC announcement of May 6, 2003, was widely interpreted to herald a prolonged period of lower short-term rales and/or the purchase of long-term bonds by the Fed to effect "casier"monetary policy:

The probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation from its already low level.