Monetary policy - United States ; Interest rates

Chan Guk Huh

English

Research Papers in Economics

FRBSF WEEKLY LETTER
Number 93-12, March 26, 1993
Interest Rate Spreads as Indicators
for Monetary Policy
Traditionally, economists have focused on aggre-
gate money stock measures such as M 1 and M2
as indicators of future economic activity. How-
ever, the relationship between these aggregates
and real GDP has deteriorated in recent years.
Thus there is a growing interest in alternative in-
dicators, some of which are conceptually quite
new compared to the conventional financial
market aggregates. For example, Kashyap, Stein,
and Wilcox (1993) examine the ratio of bank
loans to the sum of both bank loans and funds
raised through issuing commercial paper by
firms.
This Weekly Letter examines related indicators,
namely, the spread between the 6-month com-
mercial paper and the 6-month Treasury bill
rates, as well as the spread between yields on
long-term and short-term Treasury securities. His-
torically, both spreads have been useful leading
indicators of economic activity. However, they
are not infallible, and they failed to predict the
most current recession. Furthermore, continuing
financial market innovations and the changing
market environment might further undermine the
usefulness of some of these indicators as more
assets become available and as portfolio choices
. and financing sources become more diverse.
Thus, policymakers will have to rely on a broad
range of indicators, including these new
indicators.
Interest rate spreads
There are several reasons to consider interest
rates as indicators of monetary policy and future
economic growth. First, the Federal Reserve has
used an interest rate as one of its policy instru-
ments. Second, macroeconomic theorysuggests
it is through interest rates that monetary policy
actions are transmitted to the economy. For ex-
ample, when the Fed increases the money supply,
short-term rates drop, which stimulates activity
in interest-sensitive sectors. Third, studies of the
determinants of output movements conducted
since the early 1980s found that when interest
rates are considered, the monetary aggregates
lose most oftheir explanatory power, suggesting
that interest rates contain important information
about future output (Sims 1980).
Finally, the relationship between output and
monetary aggregates has deteriorated in recent
years Uudd and Trehan 1992). Econometric stud-
ies have revealed a loosening ofthe long-term
relationship between money and income when
the data for the 1980s are included (Friedman
and Kuttner, 1992). Deregulation and innovation
in financial markets are perceived to have con-
tributed to this deterioration. The same changes
also prompted policymakers to shift their focus
from a narrowly defined monetary aggregate, Ml,
which consists of fully checkable deposits and
currency in the hands of the public, to a more
broadly defined measure, M2, in an effort to find
a measure that retained a stable relationship with
output and prices. Even with M2, however, stud-
ies on money demand have found instability in
the relationship in the late 1980s.
Prompted by this experience, economists have
looked at alternative indicators, such as interest
rate spreads. The two spreads examined here
are the difference between rates on the 6-month
commercial paper and 6-month Treasury bills
(the paper-bill spread), and the difference be-
tween the yield on 10-year Treasury notes and
the yield on the 3-month Treasury bills (the yield
curve). Figures 1 and 2 plot these spreads over
the past thirty years; the shaded areas denote
recessions as designated by the National Bureau
of Economic Research.
Before 1990, there is a comovement over time
between the indicators and detrended output.
Thus, a distinct increase in the paper-bill spread
was followed by a recession (Figure 1). In the .
case of the yield curve, it turned negative im-
mediately prior to each of the recessions in that
period (Figure 2). Generally, most large move-
ments in the two rate spreads were associated
with slowdowns in detrended output. Such rela-
tionships between the spreads and output haveFigure 1: Paper Bill Spread and Output
FRBSF
Percent
4
3
2
o
-1
60
Billions
200
100
0
-100
-200
-300
65 70 75 80 85 90
Second, the pap~r-bill spread may serve as an
indicator of the stanceof monetary policy. When
there is a monetary policy tightening, bank lend-
ing contracts in response, and some firms issue
more commercial paper to raise funds. The in-
crease in the demand for credit in the commer-
cial paper market will raise the commercial paper
rate. This increase raises the paper-bill spread if
the T-bill rate does not rise proportionately. The
T-bill rate could rise, for example, if commercial
banks and other investors sell T-bills from their
portfolios and substitute for them commercial
paper to take advantage of the higher rates of
return. However, Treasury bills and commercial
paper are not perfect substitutes in the portfolios
of investors and banks, because the two types of
securities differ substantially in terms of tax treat-
ment, liquidity, and regulatory considerations.
Thus, it is likely that a contraction in economic
activity caused by a tightening of monetary
policy would be accompanied by a rise in the
paper-bill spread.
Figure 2: Yield Curve Spread and Output
been confirmed by formal statistical studies
(Esteller and Hardouvelis 1991; Friedman and
Kuttner 1992).
Why are interest rate spreads useful?
Interest rate spreads may be helpful for predict-
ing future movements in output for a number of
reasons. First, the paper-bill spread is affected by
the overall level of risk in the economy, which
rises and falls with the contractions and expan-
sions in real economic activity. The default risk
of commercial paper tends to increase when
a downturn in the economy is imminent, driv-
ing its rate up; but, since the default risk of the
government-backed Treasury bill does not rise,
its rate does not go up. Consequently, the dif-
ference between the two rates tends to widen
before the onset of a recession.
Movements in the paper-bill spread as well as
the bank loan ratio mentioned earlier are related
to the so-called "credit channel" view of how
monetary policy tightening affects output. The
option of borrowing in the private open market,
which can mitigate a cutback in bank lending,
is not fully available to all firms. Small firms, in
particular, have limited access to open financial
markets since, unlike large firms, they lack an es-
tablished name. Thus, when monetary policy is
tightened, and some larger borrowers switch to
commercial paper, some small firms are denied
credit and must curtail their business activities.
These declines in spending then contribute to
a slowdown in the pace of overall economic
activity.
The third reason why the spreads may be useful
is related to the yield curve, which depicts the
relationship between the yields on securities of
comparable risk and their terms to maturity. Most
authors have attempted to capture yield curve
effects by using the yield spread between long-
term and short-term Treasury securities. The
"expectations" theory of the term structure of in-
terest rates argues that the expected returns from
holding a long-term security until maturity should
equal the returns realized from investing in ase-
ries of short-term securities for the same period
of time. Thus, the difference between, say, the
yields on 3-month Treasury bills and10-year
Treasury notes reflects the path of expected yields
for the short-term instrument in the future.
For example, if the lO-year rate is lower than the
short-term rate, it suggests that investors expectthe short-term rate in the future to be lower than
it is today. One reason that investors might ex-
pect short-term interest rates to fall in the future
is that they expect an economic downturn. Thus,
an "inversion" of the yield curve often represents
a forecast of an economic slowdown.
Spreads during the recent downturn
As shown in the figures, prior to the1990 busi-
ness cycle peak, the interest rate spread variables
did a good job of predicting recessions. Prior to
each of the last five recessions the paper-bill
spread shot up and the yield curve consistently
turned negative. However, these spreads did not
anticipate the 1990-1991 recession: The paper-
bill spread did not show a clear increase prior to
the 1990 recession; the yield curve was not "in-
verted." Also, there was an unusually long lead
time between the dip in the spread and the onset
of the downturn.
These observations are confirmed by the recent
performance of sophisticated econometric mod-
els in which similar interest rate spreads were
used as key information variables. One example
is the National Bureau of Economic Research
Experimental Recession Probability Index. The
index includes both the paper-bill spread and a
measure of the yield curve. The index failed to
anticipate the 1990 downturn (Huh 1991).
Implications for monetary policy
This Letter briefly examined two newly pro-
posed indicators that are potentially useful for
the conduct of monetary policy. Although these
alternative indicators seem to contain informa-
tion about the future condition of the real econ-
omy when looking at earlier recessions, their
performance in predictingthe 1990 downturn
was disappointing.
Perhaps it is unrealistic to expect to find an in-
dicator that would remain consistently useful in
forecasting future movements in output for an ex-
tended period of time. First, fluctuations in output
are caused by myriad factors, such as real shocks
like the oil price shock of the early 1970s, and
monetary shocks, like the Volcker deflation of
the early 1980s. Each ofthose factors may affect
aggregate demand and supply conditions and
hence can influence financial market quantity
and price variables differently. Thus, it is remark-
able that interest rate spreads have been as con-
sistently informative as they have in the past.
Second, not only can the key factors behind
business cycles vary over time, but so can the
overall thrust of monetary policy, which influ-
ences general financial market conditions. For
example, monetary policy since the early 1980s
has placed greater emphasis on controlling infla-
tion compared to the 1970s. Thus, the informa-
tion content of some long term rates might have
shifted inthe recent period due to changes in the
expected inflation rate that makes up a part of
long rates.
Third, since the 1970s, financial markets have
been evolving rapidly, and the trend continues.
The introduction of more sophisticated financial
instruments is broadening the spectrum of avail-
able asset choices, as well as financing sources,
and hence makes substitutions between assets
more feasible and desirable and also makes the
prices and quantities ofthese assets adjust more
rapidly. This changing environment can make the
interest spreads less informative over time.
The discussion illustrates the difficulty that mon-
etary policymakers face in the current environ-
ment. In the absence of consistently reliable
indicators to gauge future changes in economic
conditions, it becomes necessary to monitor and
interpret a wide set of potentially useful indica-
tors with changing information content.
Chan Guk Huh
Economist
References
Esteller, A., and G.A. Hardouvelis. 1991. "The Term
Structure as a Predictor of Real Economic Activity!'
Journal of Finance 46, pp. 555-576.
Friedman, B., and K. Kuttner. 1992. "Money, Income,
Price and Interest Rates!' American Economic
Review 82, pp. 472-492.
Huh, C. 1991. "Recession Probability Index: A Survey."
Federal Reserve Bank of San Francisco Economic
Review (Fall), pp. 31-40.
Judd, J., and B. Trehan. 1992. "Money, Credit, and
M2." Federal Reserve Bank of San Francisco
Weekly Letter 92-30 (September 4).
Kashyap, A., J. Stein, and D. Wilcox. 1993. "Monetary
Policy and Credit Conditions: Evidence from the
Composition of External Finance!' American Eco-
nomic Review 83, pp. 78-98.
Sims, C. 1980. "Comparison of Interwar and Post-War
Business Cycles: Monetarism Reconsidered!'
American Economic Review 70, pp. 250-257.
Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of
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Phone (415) 974-2246, Fax (415) 974-3341.~ 1%\ ·S>jU! ueaqAos lU!M
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Index to Recent Issues of FRBSF Weekly Letter
AUTHOR
10/2
10/9
10/16
10123
10/30
11/6
11/13
11120
11127
12/4
12/11
12/25
1/1
1/8
1/22
1/29
2/5
2/12
2/19
2/26
3/5
3/12
3/19
92-34
92-35
92-36
92-37
92-38
92-39
92-40
92-41
92-42
92-43
92-44
92-45
93-01
93-02
93-03
93-04
93-05
93-06
93-07
93-08
93-09
93-10
93-11
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The FRBSF Weekly Letter appears on an abbreviated schedule in June, July, August, and December.

Comparison of Interwar and Post-War Business Cycles: Monetarism Reconsidered!'

Monetary Policy and Credit Conditions: Evidence from the Composition of External Finance!'

Money, Credit, and M2.&quot; Federal Reserve Bank of San Francisco Weekly Letter

Money, Income, Price and Interest Rates!'

Recession Probability Index: A Survey.&quot; Federal Reserve Bank of San Francisco Economic Review (Fall),

The Term Structure as a Predictor of Real Economic Activity!'

Interest rate spreads as indicators for monetary policy

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Interest rate spreads as indicators for monetary policy

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