Accounting for the bond-yield conundrum

Abstract

Long-term interest rates tend to rise as monetary policymakers increase short-term interest rates. This relationship didn't hold, however, during the recent U.S. monetary policy tightening cycle. Between June 2004 and June 2006, the Federal Open Market Committee increased the federal funds rate 17 times - going from 1 percent to 5.25 percent. Yet, long-term interest rates declined or stayed flat until early 2006. ; This divergence between short- and long-term interest rates caught many economists, investors and central bankers by surprise. In his Feb. 16, 2005, congressional testimony, former Federal Reserve Chairman Alan Greenspan characterized the behavior of long-term interest rates since June 2004: "For the moment, the broadly unanticipated behavior of world bond markets remains a conundrum. Bond price movements may be a short-term aberration, but it will be some time before we are able to better judge the forces underlying recent experience." ; Since then, this conundrum has prompted a great deal of discussion regarding both its magnitude and the factors behind it. However, a compelling and broadly accepted explanation has yet to be reached. ; The correct understanding and quantification of the conundrum have direct implications for monetary policy, which largely impacts economies as long-term interest rates respond to changes in central banks' target rates. Persistent changes in the relationship between short- and long-term interest rates will affect the timing and impact of monetary policy actions.Monetary policy - United States ; Federal funds rate ; Federal Open Market Committee ; Bond market