Full text of Economic Synopses : Another Conundrum?, 2008, No. 23

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Economic SYNOPSES
short essays and reports on the economic issues of the day
2008 ■ Number 23

Another Conundrum?
Kevin L. Kliesen
n 2004, former Federal Reserve Chairman Alan Greenspan
result is a real federal funds rate of –3.5 percent. At the same
expressed surprise that long-term nominal interest rates
time, the 10-year Treasury yield has declined. After the slight
(e.g., 30-year conventional, fixed mortgage rates) failed
increase in consumers’ inflation expectations from April to
to increase as the Federal Open Market Committee (FOMC)
June 2008, expectations have partially reversed.1
Why have financial market participants and consumers been
increased its federal funds interest rate target. Greenspan and
so
sanguine
in the face of these price pressures? First, financial
others dubbed this a “conundrum.” Today, a different type of
markets
may
have a “Phillips curve” view of the world—that is,
financial market conundrum may have arisen: Why, with a
markets
may
expect
much weaker output growth for the rest of
high and rising overall U.S. and global inflation rate, has the
2008 and into 2009 that will dampen inflation pressures. This
nominal yield on the 10-year U.S. Treasury security remained
effect also will tend to reduce the real yield component, so it
below 4 percent for most of the past year?
could have no net effect on expected inflation. Second, the
Long-term Treasury yields often are viewed as a key baromrecent decline in energy and commodity prices suggests that
eter of inflation pressures. This rationale stems from the Fisher
the previous price increases were temporary, which may lead
equation, which holds that the nominal yield is the sum of
to lower overall inflation and, perhaps, eventually eliminate the
the real yield and a premium to compensate bondholders for
second-round effects. Some FOMC members favor this view.
inflation and the risk of higher inflation. Accordingly, a rise
Finally, and perhaps most significantly, financial markets
in 10-year Treasury yields, without a concomitant increase in
and
consumers may believe that the long-term inflation rate
the federal funds rate, often is attributed to the market’s expecis
significantly
lower than the current inflation rate. The implitation of increased long-term inflation.
cation
is
that
a
failure of the current inflation rate to moderThe U.S. economy has experienced significant price presate
will
be
aggressively
countered by the FOMC to avoid an
sures lately—mostly from the direct effects of large oil, gasoline,
increase
in
long-run
inflation
expectations. However, should
and commodity price increases. A sizable decline in the U.S.
the markets lose confidence in the FOMC, the nominal longdollar has also helped to boost prices of nonpetroleum imported
term interest rate would likely rise markedly. ■
goods. The overall effect has been a 4.1 percent annual increase
1 Inflation expectations of consumers over the following 12 months rose considin CPI for 2007 (its highest rate in 17 years) and a 6.2 pererably higher, reaching 5.25 percent in June 2008.
cent increase in the year to July 2008.
Producers seem to be increasingly able to pass
along higher input price increases to offset their
A Picture of Credibility?
shrinking profit margins: The “core” CPI (less food
Percent
and energy), after averaging 2.3 percent from 2005 to
6.0
2007, has increased at a 3.5 percent annual rate over
5.0
the three months ending in July 2008, which makes
the relatively low level and volatility of the 10-year
4.0
U.S. Treasury rate even more puzzling.
3.0
The chart plots the nominal yield on the 10-year
U.S. Treasury security and the FOMC’s federal funds
2.0
target rate, the year-to-year percent change in the CPI,
10-Year Treasury
Federal Funds Rate
1.0
and the University of Michigan’s survey of consumers’
CPI Inflation
Inflation Expectations
expectations for inflation over the next 5 to 10 years.
0.0
Jan-07
Apr-07
Jul-07
Oct-07
Jan-08
Apr-08
Jul-08
Oct-08
Over the past year, the FOMC has aggressively reduced
NOTE:
The
inflation
rate
is
through
July
2008;
the
remaining
data
are
through
August
2008.
the federal funds target rate against the backdrop of
a rapid acceleration in the overall inflation rate. The

I

Views expressed do not necessarily reflect official positions of the Federal Reserve System.

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