Tuesday, June 29, 2010
Andy Harless presents the case for a double dip (second recession) - I would re-order #1 and #2 on that list - and that for a sustained recovery. #6 of Andy's case for a sustained recovery (he calls it Case Against a Second Dip) caught my attention, pointing me to an earlier Paul Krugman article about positively-sloped yield curves in a zero-bound policy environment.
In a related article, Krugman argues that a current policy of near-zero short-term rates precludes the lowering further of future short-term rates. Therefore, the steep yield curve reiterates that rates have nowhere to go but up rather than that the economy is expected to improve.
Reasonable; but it was Krugman's comparison to policy during Japan's lost decade that got the mental wheels rolling:
Indeed, if we look at Japan we find that the yield curve was positively sloped all the way through the lost decade. In 1999-2000, with the zero interest rate policy in effect, long rates averaged about 1.75 percent, not too far below current rates in the United States.In my view, current Fed policy is generally more credible than policy undertaken by the Bank of Japan in the early 2000's. The fed funds target has been near-zero since December 2008; and the new reserve base (liquidity) peaked quickly since the onset of QE and has since remained in the banking system.
Therefore, it would stand to reason that as long as policy remains consistent and big (the latter on the fiscal side is the problem right now), the US yield curve can, in my view, be interpreted as an auspicious sign - all else equal, as they say - as compared to the positively-sloped one in Japan.
Monetary policy in Japan: 1998 - 2006
The Bank of Japan has a solid history of rescinding their own policy efforts. They did it earlier this year; but more importantly their policy announcements spanning the years 1999 to 2006 have on occasion been rather deceiving. Notice that the 2-10 yield curve never became inverted.
The shortened version of the timeline (illustrated in the chart above):
- From Bernanke, Reinhart, and Sack (2004): "In April 1999, describing the stance of monetary policy as “super super expansionary,” then-Governor Hayami announced that the BOJ would keep the policy rate at zero “until deflationary concerns are dispelled,” with the latter phrase clearly indicating that the policy commitment was conditional."
- In August 2000, The BoJ raises the overnight call rate to 0.25%, up from near-zero.
- In February 2001 the BoJ lowers the overnight call rate to 0.15%.
- In March 2001, the BoJ announces its quantitative easing strategy, initially targeting current account balances (essentially reserves) at 5 trillion yen and lowered the overnight call rate target to near-zero.
- Until 2004, the BoJ raises the current account reserve target several times until it peaks at 30-35 trillion yen.
- In March 2006, the BoJ exits QE.
To be sure, the likelihood of rates rising is the only possibility built into the US yield curve right now (no possibility of lower rates); but since the Fed is relatively more credible and consistent, the probability of rates rising is much higher compared to that in early 2000's Japan.
And the current US curve is steep! The chart below compares the dynamics of the 2-10 yield curve in Japan from its low in 1998 through 2006 to that in the US from its low in 2007 through June 24, 2010.
Reference for paper in final chart: Luc Laeven and Fabian Valencia (2008), Systemic Banking Crises: A New Database, IMF Working Paper WP/08/224.