speeches · September 3, 2003
Speech
William Poole · President
Prospects and Risks in the Bond Market
St.LouisFinancialAnalystsSociety
St.Louis,Missouri
September4,2003
I’m pleased to be here today to discuss an theactualfedfundsrateclosetotheintended
issue dear to all of our hearts: Long-term rate.Thisinstitutionalfacthastheunfortunate
interest rates and their recent behavior. sideeffectofleadingsometobelievethatthe
The gyrations of the bond market since FederalReservehasmorecontroloverinterest
the beginning of May have created considerable ratesthanitinfactdoes.
discussion.Someinthefinancialpressandsome Let’sstartthestoryatthebeginning.TheFed
haspricestabilityandeconomicgrowthobjec-
tradersaskwhethertheFedsentconfusingsignals
tives.Pricestabilityrequiresmaintenanceoflow
aboutprospectsformonetarypolicy;otherswon-
andstableinflation.Pricestabilitycontributes
derinsteadwhetherthebondmarketsmisunder-
directlytoeconomicgrowth;inaddition,timely
stood and overreacted to Fed announcements.
policyadjustmentscanhelptoreducefluctua-
Ratherthandiscusstheseissues—whichhave
tionsinemploymentandoutput.
reacheda“he-said,she-said”standoff—Iwould
PutasidefornowthefactthattheFOMC
liketostepawaytoreviewthebasicsofthebond
implementspolicybysettingtheintendedfederal
market.I’veoftenfeltthatlonger-runfundamen-
fundsrate,andconcentrateinsteadontheobjec-
talstendtogetlostinawelterofshort-runcon-
tivesofpolicy.Inrecentyears,successisalmost
siderationsthatfadeintooblivionquitequickly
absolutewithrespecttoinflationandexpected
asanewsetofshort-runconcernsdominatethe
inflation,bothofwhicharelowandstable.Suc-
news.I’lldiscussthefundamentaldeterminants
cessisconsiderable,butincomplete,intermsof
oflong-terminterestrates,whichI’llindexbythe
outputandemployment.Idonotmeantoimply
benchmarkyieldon10-yearTreasurybonds.
thattheFedcouldhavedonemore,buttheecon-
Beforeproceeding,Iwanttoemphasizethat omy’sperformanceoverthelastfewyearshasnot
theviewsIexpressherearemineanddonot beenasrobustaseveryonewants.Unemployment
necessarilyreflectofficialpositionsoftheFederal increasedasaconsequenceofthemild2001
ReserveSystem.Ithankmycolleaguesatthe recessionandhascontinuedtorisesincethe
FederalReserveBankofSt.Louisfortheircom- recessionendedinNovember2001becausethe
ments;ChristopherJ.Neely,Researchofficerat paceofrecoveryhasbeenmodest.
theBank,providedspecialassistance.However, I’dliketoconvinceyouthatinpracticethe
Iretainfullresponsibilityforerrors. Fedhasnolatitudeastohowtosettheintended
federalfundsrate,exceptformattersofshort-term
timing,ifitwantstoachieveitsobjectives.Low
FUNDAMENTAL DETERMINANTS andstableinflation,andoutputgrowthalongits
long-rungrowthpath,implyacertain,though
OF INTEREST RATES
notconstant,long-terminterestrate.TheFed
TheFederalOpenMarketCommittee(FOMC) mustdeliverapathfortheintendedfederalfunds
implementsmonetarypolicybysettingan rateconsistentwiththedesiredoutcomesforthe
intended,ortarget,federalfundsrate,andthen economyinordertorealizethoseinflationand
engaginginopen-markettransactionstokeep outputgoals.
1
FINANCIALMARKETS
Economiststhinkofthebenchmark10-year italspendingbyissuingbonds.Iftherealinterest
Treasuryrateashavingthreecomponents:the rateistoolowrelativetotheexpectedreturnon
realrateofinterest,expectedinflation,andarisk newinvestmentinplantandequipment,then
premiumforunexpectedinflation.I’lldiscussthe therewillbeexcessdemandforfundstobuild
determinantsoftherealrateofinterestlast. physicalcapitalandtherealinterestratewillbe
Theexpectedinflationcomponentisnotdif- bidup.Conversely,iftherealinterestrateistoo
ficulttounderstand.Inflationeatsawaythepur- highrelativetoexpectedreturns,thentherewill
chasingpowerofabond;borrowerscanpayoff beanexcesssupplyoffundsandtherealinterest
theirdebtswithdollarsofdepreciatedpurchasing ratewillbebiddown.Throughtheseopportuni-
power.Ifexpectedinflationrisesby1percentage tiesforsubstitutingcapitalforbonds,orviceversa,
point,thennominalinterestrateswillriseby1 therealrateofreturnonbondsislinkedtothe
percentagepointtoo,allelseequal.Byfarthe realrateofreturnoncapital.
mostimportantreasoninterestratestodayare Arobusteconomyandhighproductivity
farbelowtheirlevelsin1981isthatactualand meansthatbusinesseswillseektoborrowto
expectedinflationaremuchlowernow. financefutureproduction,whichwillbidup
Nooneknowsexactlywhatinflationwillbe, interestrates.Higherlevelsofeconomicactivity
solendersmustbecompensatedforthefactthat meanhigherinterestrates,allelseequal.The
couponandprincipalpaymentswillhaveuncer- principalreasonthe10-yearbondrateislower
tainpurchasingpower.Inflationuncertaintyisthe todaythanitwasatitsmonthlypeakinJanuary
sourceofanothercomponentofnominalinterest 2000isthatthedemandforfundstofinancecapi-
rates.Themorevolatileandunpredictableisinfla- talinvestmentismuchlowertodaythanitwas
tion,thehigheristhiscomponentofthenominal attheheightofthepreviouseconomicboom.
rate—theinflationriskpremium.Today,inflation Weseethissameeconomicforceatwork
isexpectedtobefairlystable,sotheinflationrisk whencomparinginterestratesintheUnited
premiumisprobablysmall,certainlyconsider- StateswiththoseinJapan.Japanhasbeengrow-
ablylessthaninthelate1970s.Itisverydifficult ingveryslowlyforadecade,goinginandoutof
tosortoutinflationexpectationsfrominflation recession.Thedemandforfundsislowbecause
uncertainty;I’lllumpthetwotogetherandsimply profitableinvestmentopportunitiesareviewed
talkofinflationexpectations. aslimited.Incontrast,theU.S.situationtodayis
I’vementionedthatthelargedeclineininter- viewedmuchmoreoptimistically,eventhough
estratesafter1981wasduetoalargedeclinein notasoptimisticallyasitwasfouryearsago.
inflationexpectations.Ifweexamineinterest Allofthesecomponentsofinterestratesare
ratesoveraperiodwheninflationchangedalot, forwardlooking;theydependonexpectations
oracrosscountrieswithverydifferentinflation aboutthefuture.Wecan’tdirectlyobservethese
rates,we’llfindthatmostofthevariationofrates componentsoflong-terminterestrates,butwe
isduetovariationofinflation.Butwhenweexam- canestimatethem.
ineratesoveraperiodcharacterizedbyinflation Measuringexpectationsisinherentlydifficult,
stability,oracrosscountrieswithsimilarinflation butourtoolsforestimatingexpectedinflation
rates,theninterestratevariationcannotbeattrib- haveimprovedsignificantlyinrecentyears.
utedtoinflation.Theobservedvariationover Primarily,weusesurveyexpectationsofinfla-
time,ordifferencesacrosscountries,reflects tionorthedifferencebetweenyieldsonregular
forcesdeterminingtherealrateofinterest. TreasurybondsandTreasuryinflation-indexed
Therealratedependsmostcentrallyonthe securities(TIIS),whichI’llcallsimply“indexed
expectedproductivityofphysicalcapital.Investors bonds”forshort.
canchoosewhethertoholdbondsorphysical Indexedbonds,firstissuedbytheTreasury
capital,orequityclaimstophysicalcapital,in in1997,containaprovisionthatincreasestheir
theirportfolios.Firmscanchoosetofinancecap- principalandeverysemiannualinterestpayment
2
ProspectsandRisksintheBondMarket
bytheincreaseintheconsumerpriceindexfrom risesandfallsofdefaultriskarequitenaturally
thedateofissue.Thesebonds,therefore,com- linkedtothestateoftheeconomy.
pletelyprotecttheinvestorfromtheeffectsof Onefinalcomponentofinterestratesarises
inflation;theyieldonthebondsisbydefinition fromtheliquidityorilliquidityofthebond.Bonds
arealyield.Ifweassumethattheinflationrisk thatareactivelytradedinlargevolumearehighly
premiumisnegligible,thenthedifferencebetween liquid.Aninvestorcanbuyorsellsubstantial
theyieldonaconventionalbondandaTIISbond amountswithlittleornoimpactonyield.Even
measuresthemarket’sexpectationoffutureinfla- withintheTreasurymarket,weobservesignifi-
tion.Forexample,examiningbondsmaturingin cantdifferencesinliquidityofvariousissues.
approximately10years,yesterdaytheindexed Tradingtendstobeconcentratedinbenchmark
bondhadayieldof2.38percentwhileaconven- issues,suchasthe10-yearmaturity.Bondswith
tionalTreasurybondhadayieldof4.53percent. 9yearstomaturityand11yearstomaturitytrade
Thesetwobondswillturnouttohaveidentical atayieldafewbasispointshigherthanthe10-
yieldsiftheinflationratebetweennowand2013 yearbond.
averages2.15percent,thedifferencebetween
thetwoquotedyields.Asafirstapproximation,
wecansaythatthesetwoassetmarketsarepro- A REVIEW OF MAJOR INTEREST
vidinguswiththeinformationthatinvestors
RATE DEVELOPMENTS
expectthattheinflationratewillaverage2.15
Thesefundamentalconceptsarewhatwe
percentoverthenext10years.
needtounderstandinterestratedevelopments
Theexpectedrateofinflationdependsboth
inrecentyears.Usingannualdata,thepeakyear
onwhattheFedsaysandwhatithasdone.Mar-
forthe10-yearTreasurybondratewas13.91per-
ketspayattentiontowhattheFedsaysitwants
cent,in1981.It’shardtoknowexactlywhatthe
todobecauseithasbuiltupareservoirofcredi-
realratewasatthattimebecauseunambiguous
bilitybyprovidinglowandstableinflationfor
dataarenotavailable.However,thepremiumfor
sometime.Butwordsaren’tenough.Ultimately,
anycentralbank’spolicyactionsmustbeconsis- inflationexpectationsandinflationuncertainty
tentwithitswordsoritwilllosethepublic’strust. wassurelyquitelarge.
IftheFeddoesn’tmaintainpoliciesconsistent After1982,inflationfelltothe4percentrange
withlowinflation,inflationexpectationswill butinterestratesremainedquitehigh.The10-
begintorise.Andifinflationexpectationsrise, yearratewasabove8percenteveryyearinthe
long-terminterestrateswillalsorise—holding 1980s,exceptfor1986,whenitaveraged7.68
allelseconstant. percent.Astheeconomygrewafterthemild
So,yieldsonlong-termTreasurybondshave recessionof1990-91,thebondrateactuallyfell
anexpectedinflationcomponentandarealcom- slowlyonaveragethroughtheendof1998.Along-
ponent.Theyieldsonotherbonds,suchascor- termdeclineinbondratesduringaneconomic
poratebonds,containanothercomponent:credit expansionisadecidedlyrareevent,asratestypi-
risk.Theinterestdifferentialdependsonthepos- callyriseduringanexpansion.Decliningexpected
sibilitythattheborrowerwilldefault.Creditrisk inflationanddeclininginflationriskexplain
dependsontheindividualbondissuerandoften thisoutcome.Basedonsurveydata,expected
changesoverthecourseofthebusinesscycle, CPIinflationdeclinedfromroughly5percentat
increasingasbusinessconditionsdeteriorate.The thebeginningof1990toabitover2percentat
mostdramaticexampleofthisphenomenonis theendofthedecade.Isuspectthatdeclining
thatthespreadbetweenyieldsonjunkbonds inflationriskalsocontributedtothedeclinein
andgovernmentbondstendstowidenduring bondrates,butnosatisfactoryseriesoninflation
recessionsandnarrowduringexpansions.The riskexists.
3
FINANCIALMARKETS
Thedeclineinratesinthesecondhalfof duringthisperiod,butmostofthedeclineinthe
1998reflectedconcerns,inthemarketsandin bondratereflectedadeclineintherealrateof
theFOMC,abouttheeffectsoftheRussiandefault interest.Bythemiddleofthisyear,the10-year
inAugustandthesevereproblemsfacedbyLong indexedbondyield,whichhadbeenabout4.4
TermCapitalManagement,whichbrokeintothe percentinlate1999,wasdowntoabout1.5per-
openinSeptember.Bytheendoftheyear,the cent.Thatyield,bytheway,hasnowrebounded
economyshookofftheseconcernsandtheeco- toabout2.4percent.
nomicboomresumedinfullforcein1999.The Ithinkthattherightinterpretationofthe
demandforcapitalwashigh,andhandsome reboundintherealrateofinterestinrecentweeks
returnsinthestockmarketledinvestorsinthat isthatthemarketexpectsaresumptionofeco-
directionawayfrombonds.Tokeepinflation nomicgrowth,withaccompanyingresumption
undercontrolandtempertheboom,theFed ofstrongercreditdemands.Ibelievethatthe
raisedtheintendedfederalfundsrate. evidenceforthisinterpretationissubstantial,
Usingdataonindexedbonds,firstissuedin becauseweknowfrompreviousbusinesscycles
1997,wehaveaprettygoodfixonrealinterest andfromcross-countryevidencethatthereal
rates.Astheeconomicboomintensifiedoncethe rateofinteresttendstobehigherineconomies
economygotpastthedisruptioninthefallof withhighergrowthrates.
1998,realratesrose.The10-yearindexedbond
yieldpeakedatabout4.4percentinJanuary
2000,butinflationexpectationsremainedinthe THE IMPORTANCE OF
neighborhoodof2percent.Accordingly,the10- TRANSPARENCY
yearnominalTreasurybondyieldalsopeakedin
I’veconcentratedonlonger-runfundamentals
January2000,atabout6¾percent.
becauseIthinkthatistherightplacetolookfor
Astheeconomysoftenedoverthecourseof
explanationsofsignificantchangesininterest
2000andreachedabusinesscyclepeakinMarch
rates.Themarketisconstantlyseekingtounder-
2001,bondratesbegantofall.TheFedbeganto
standthelonger-rundirectionoftheeconomy;
easepolicyinJanuary2001.Interestingly,bond
however,trendsarealwayseasytoidentifyafter
ratesinitiallyrose,asthemarketapparently
thefactanddifficulttoreadinrealtime.
believedthatFedeasingwouldstimulatethe
Ontopofthelonger-runtrendsininterest
economyfairlyquicklyandleadtoaresumption
ratesisanoverlayofshort-runnoise.By“noise”
ingrowthofcreditdemands.Thatwasnottobe;
Imeansmallday-to-dayandweek-to-weekfluc-
asweknownow,theeconomycontinuedtodrift,
tuationsthatlaterturnouttoreflectmispercep-
firstinthemildrecessionthatlastedfromMarch
tions,verytemporaryliquiditychanges,andsuch
toNovemberof2001andthenonlymodestlyup
things.Ifyoulookatagraphofquarterlyaverage
in2002.
data,muchofthenoisedisappears.Ifyoulookat
Onseveraloccasionsoverthelastthreeyears, agraphofdailydataandgobacktothedaily
forecastsofmorebuoyantgrowthweredisap- financialpress,youwillseethenews,rumors,
pointed.Thecombinationofcapitaloverhang andspeculationsthatliebehindmuchofthe
fromtheinvestmentboomofthelate1990s, noise.Ifyougobacktothedailynews,whichI
shocksfrommajorbankruptcies,thetragedyof didatgreatlengthasanacademicbeforeIcame
9/11,andcorporategovernancescandalsheld totheFed,youwilllikelybeboredbymostof
theeconomyback.Whenexpectedincreasesin whatyouread.Mostoftheaccountsdescribe
creditdemandsdidnotmaterializeandwiththe noisethathasnovalueinunderstandingthe
disappointingperformanceofthestockmarket, fundamentalsdrivinglonger-rundevelopments.
investorsbidbondratesdown.Long-terminfla- Thestanceofmonetarypolicyisoneofthe
tionexpectationsmayhavedrifteddownalittle fundamentalsinthelargerpicture,becauseifthe
4
ProspectsandRisksintheBondMarket
Fedgetsitwrong,thentheeconomywillnotgrow WhatoughttobepredictableistheFed’scommit-
alongitpotentialgrowthpathwithlowandstable menttoitspolicygoalsanditsresponsetoevents
inflationandinterestrateswillnotsettleat,or astheyoccur.Fedresponsesarenotperfectly
fluctuatearound,thelevelappropriatetoan predictabletodaybecausenooneinsideoroutside
economygrowingatitsfullpotential. theFedknowshowtowriteanexplicitrecipe
Becauseofthemarket’sintenseinterestin forconductingpolicy.However,thereisample
monetarypolicy,theFOMChasamajorcommu- evidencethatpolicyissubstantiallypredictable,
nicationschallenge.Ispokeinsomedetailonthat asthemarketandtheFedmostoftendoreadthe
topicinaspeechtwoweeksagoinPhiladelphia, implicationsofarrivinginformationthesameway.
anddonotwanttorepeatthatentirediscussion
here.ThebottomlineisthatoneoftheFed’sjobs
istocommunicateasaccuratelyaspossibleso CONCLUDING COMMENTS
themarketcandetermineinterestratesefficiently.
NowI’llpulltheanalysistogether.Withregard
ThatmeansthattheFedneedstodothebestit
toinflationexpectationsandinflationrisk,
cantoconveytheessentialelementsofpolicy
prospectsgoingforwardareexcellent.Actual
clearlyandnotitselfbeasourceofshort-run
andexpectedinflationhavebeenquitestablein
noiseinthemarket.Tome,anessentialingredi-
recentyears,andthereiseveryreasontoantici-
entofgoodFedcommunicationsistofocuson
patethattheseattractiveconditionswillremain
longer-runfundamentalsandonhowtheFOMC
inforce.Themarketappearstohavegreatconfi-
pursuesitsobjectivesbyadjustingthestanceof
denceintheFederalReserve’scommitmentto
policytothearrivalofnewinformation.
pricestabilityanditspowerstomaintainthe
EveniftheFedweretocommunicateits
inflationratewithintherangeofexperienceof
objectivesandmethodsperfectly,thefuturepath
recentyears.Moreover,thestunningincreasein
ofthefederalfundsratewouldneverbeperfectly
productivityinthesecondquarterannounced
predictablebecausetheFOMCmustchangethe
intendedratefromtimetotimeasnewinforma- thismorningandthestrongcasethathandsome
tionarrives.Nottodosowouldcreateproblems, productivityincreaseswillcontinue—evenifnot
suchastheGreatInflationofthe1970s.Thatinfla- asstunningasthesecondquarterdata—makes
tionwasaconsequenceofpolicyadjustments inflationcontrolconsiderablyeasierthanitother-
thatweretoofrequentlytoolittleandtoolate.In wisewouldbe.Althoughwemustalwaysbealert
theend,thosepolicymistakesledtomoreuncer- toinflationordeflationsurprisescomingoutof
tainty,becauseoftheinflation,andlargerinterest thewoodwork,thereis,inmyview,theprospect
ratechangesthanwouldhaveoccurrediftheFed goingforwardthatinflationwillbebenignand
hadbeenwillingtoactearlieranddecisively. thattherisksinthisdirectionareaslowaswe
GiventhattheFOMCmustrespondintimely haveseeninthelast40years.
fashiontonewinformation,andcertainlyhasfor Withregardtoprospectsandrisksonthereal
atleast20years,I’llmaketheclaimthatmis- rateofinterest,mymessageisthattherisksare
communicationaccountsforonlyatrivialfraction tiedtoriskswithrespecttoeconomicgrowth.As
ofinterestratechangesinrecentyears.Incident- Iexaminegrowthexpectationsofprofessional
ally,“respondintimelyfashion”doesnotneces- forecasters,suchastheBlueChippanel,myread
sarilyimplyfrequentpolicyadjustments.Inthe isthattheconsensusoutlookisforsolidandbal-
morestableinflationenvironmentweenjoytoday, ancedeconomicgrowthgoingforward.However,
theFedhasfarmorefreedomthanithadinthe asIalwaysemphasizewhendiscussingtheeco-
1970stowaitforinformationtoaccumulate. nomicoutlook,forecastschangeovertime,some-
Becausetheeventsthatdrivechangesinthe timessignificantly,andatanygiventimethereis
stanceofpolicyareunpredictable,theintended arangeofprofessionalopinionontheoutlook.
federalfundsratecannotitselfbepredictable. Shouldweseeacontinuationofasluggishrecov-
5
FINANCIALMARKETS
ery,thentheprospectsarethatbondrateswill
fallsomewhatfromcurrentlevels.Shouldwe
seeagangbustersrecovery,thentheprospects
arethatrisingcreditmarketswilldrivebondrates
abovecurrentlevels.Ineithercase,theaction
willbeprimarilyintherealrateofinterestand
not,Ibelieve,intheinflationpremiumcompo-
nentofrates.
6
Cite this document
APA
William Poole (2003, September 3). Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/speech_20030904_poole
BibTeX
@misc{wtfs_speech_20030904_poole,
author = {William Poole},
title = {Speech},
year = {2003},
month = {Sep},
howpublished = {Speeches, Federal Reserve},
url = {https://whenthefedspeaks.com/doc/speech_20030904_poole},
note = {Retrieved via When the Fed Speaks corpus}
}