The Fed and the shape of the yield curve

By Dr Frank Shostak

For many commentators, a change in the shape of the differential between the long-term interest rate and the short-term interest rate i.e., the yield spread provides an indication of the likely direction of the economy in the months ahead. Thus, an increase in the yield spread raises the likelihood of a possible strengthening in economic activity in the months to come. Conversely, a decline in the yield spread is seen as indicative of a possible economic downturn ahead. 

A popular explanation regarding the shape of the yield curve is provided by the expectations theory (ET). According to the ET, expectations for an increase in the short-term interest rate sets in motion an upward sloping yield curve. While the expectation for a decline in the short-term interest rate sets the downward sloping yield curve.  

In the ET framework, it is the average of the current and expected short-term rates, which determines the current long-term interest rate. According to the ET whenever investors start to anticipate economic expansion, they also begin to form expectations that the central bank is going to raise short-term interest rates by lifting the policy interest rate.  

To avoid capital losses investors are likely to move their money from long-term securities to short-term securities. (A rise in interest rates will have a greater impact on the prices of long-term securities versus short-term securities). This shift will bid short-term securities prices up and lower their yields. With respect to long-term securities, the shift of money away will depress their prices and raise their yields. Hence, we have here a decline in short-term yields and an increase in long-term yields – a tendency for an upward sloping yield curve emerges. 

Conversely, it is held that whenever investors expect an economic slowdown or a recession, they also start forming expectations that the central bank is likely to lower short-term interest rates by lowering the policy interest rate.  

Consequently, investors are likely to shift their money from short-term securities towards long-term securities. Thus, the selling of short-term assets will result in a fall in their prices and a rise in their yields. A shift of money towards long-term assets will result in the increase in their prices and a decline in their yields. Hence this shift in money raises short-term yields and lowers long-term yields i.e., there is a tendency for a downward sloping yield curve to emerge. 

In the ET framework, given that the central bank determines short-term rates via the policy rate it also follows that in this framework interest rates i.e., both short-term and long-term are determined by the central bank.  

Does the central bank determine interest rates? 

The phenomenon of interest is the outcome of the fact that individuals assign a greater importance to goods and services in the present versus identical goods and services in the future. The higher valuation is not the result of some capricious behaviour, but because of the fact that life in the future is not possible without sustaining it first in the present 

If the means at an individual’s disposal are only sufficient to accommodate his immediate needs, he is most likely going to assign a low importance to future ends. With the expansion of the pool of means, however, the individual can now allocate some of the means towards the accomplishments of various ends in the future. The individuals’ time preference will be lowered i.e., we will have the lowering of the interest rate. 

Again, with the expansion in the pool of means, individuals are able to allocate more resources towards the accomplishment of remote goals in order to improve their quality of life over time.  Observe that the interest rate is just an indicator as it were which reflects individuals’ decisions regarding the present consumption versus the future consumption.  

In a free unhampered market, fluctuations in interest rates are going to be in line with changes in consumers’ time preferences. Thus, a decline in the interest rate is likely to be in response to the lowering of individuals’ time preferences.  

Consequently, when businesses observe a decline in the market interest rate, they are likely to respond to this by lifting their investment in tools and machinery in order to be able to accommodate in the future the expected increase in the consumer goods demand.  

Shape of the yield curve in an unhampered market 

According to Ludwig von Mises, in a free unhampered market economy, the natural tendency of the shape of the yield curve is neither towards an upward sloping nor towards a downward sloping but rather towards being horizontal. (Observe that the horizontal yield curve emerges after adjusting for risk.) 

Similarly, Murray Rothbard held that in a free unhampered market economy, an upward sloping yield curve could not be sustained for it would set in motion an arbitrage between short and long-term securities. Funds would be shifted from short maturities to long maturities. This would lift short-term interest rates and lower long-term interest rates, resulting in the tendency towards a uniform interest rate throughout the term structure.  

Arbitrage is likely to prevent the sustainability of a downward sloping yield curve by shifting funds from long maturities to short maturities thereby flattening the curve.  

The Fed’s tampering alters the shape of the yield curve 

The Fed’s monetary policies disrupt the natural tendency towards uniformity of interest rates along the term structure.  This disruption leads to the deviation of market short-term rates from individuals’ time preference rates. This deviation in turn leads to the misallocation of resources and to the phenomenon we know as the boom-bust economic cycle. 

As a rule, Fed policy makers decide about the interest rate stance in accordance with the observed and the expected state of the economy and price inflation. 

Thus, whenever the economy is starting to show the signs of weakness and the rate of increase of various price indexes starts to ease, investors in the market begin to form expectations that in the months ahead the Fed is going to lower its policy interest rate.   

As a result, short-term interest rates begin to move lower. The spread between long-term rates and short-term rates starts to widen and the process of the development of an upward sloping yield curve is set in motion.  

This process however, cannot be maintained without the Fed’s actually lowering of the policy rate. For the positive sloped yield curve to be sustained the central bank must persist with its intervention. 

Should the central bank cease with its easy monetary policy the shape of the yield curve would tend to flatten.   

Equally, whenever economic activity shows signs of strengthening, coupled with a rise in price inflation, investors in the market start to form expectations that in the months ahead the Fed is going to lift its policy rate. As a result, short-term interest rates begin to move higher.  

The spread between the long-term rates and the short-term rates starts to decline – the process of the development of a downward sloping yield curve is now set in motion. This process however, cannot be sustained without the Fed actually lifting the policy rate.   

Note that the Fed’s tampering with short-term interest rates distorts the natural tendency of the yield curve to gravitate towards the horizontal shape. 

Whenever the central bank reverses its monetary stance that alters the shape of the yield curve this sets in motion either an economic boom or an economic bust  These booms and busts arise with the time lags. This is because the effects of a change in monetary policy move gradually from one part of the economy to another, from one individual to another individual.  

Conclusions 

A change in the shape of the yield curve emerges in response to Fed’s policy makers setting targets to the federal funds rate. We hold that both the upward and the downward sloping yield curves are the outcome of the central bank tampering with financial markets. This tampering results in the deviation of the market interest rates from the time preference interest rates. Consequently, this results in the boom-bust cycles. We hold that in a free unhampered market after adjusting for risk, the shape of the yield curve is going to be horizontal.  

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