The Unusual Behavior of the Federal Funds and 10-Year Treasury Rates: A Conundrum or Goodhart’s Law?

Excerpted from a piece by Daniel L. Thornton of the Federal Reserve Bank of St. Louis:

In February 2005, former Chairman Alan Greenspan referred to the decline in long-term rates in the wake of the Fed increasing the target for the federal funds rate by 150 basis points as a "conundrum." Greenspan’s remarks generated considerable interest and research. I show that the relationship between the 10-year Treasury yield and the federal funds rate changed dramatically in the late 1980s, well in advance of Greenspan’s observation. I argue that the marked change in the relationship between the federal funds rate and long-term yields is a natural consequence of Goodhart’s Law.

It is widely recognized that the relationship between the federal funds rate and long-term rates, such as the 10-year Treasury yield, has changed since about 2004. Attention was brought to this fact when, in his February 17, 2005 testimony before the Committee on Banking, Housing, and Urban Affairs of the U.S. Senate former Chairman Greenspan observed that long-term rates had trended lower despite the 150 basis point rise in the Federal Open Market Committee’s (FOMC’s) target for the federal funds rate. Greenspan termed the aberrant behavior of the 10-year Treasury yield relative to the funds rate a "conundrum."

I argue that the change in the relationship between the federal funds rate and long-term yields occurred much earlier in the late 1980s and is a natural consequence of the fact that the FOMC began targeting the funds rate to achieve its policy objective. That is, the change in the relationship between the funds rate and long-term rates is an instance of Goodhart’s Law—"any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes."

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The reason for the change in the relationship is straightforward. Before the FOMC began targeting the funds rate for policy purposes, the funds rate and other rates responded to information that altered market participants’ expectations about economic fundamentals going forward. While rates responded to this information differently, the fact that all market rates respond to the same information means that a statistical relationship among rates exists. Once the FOMC began targeting the funds rate to implement monetary policy, however, the relationship changed. The federal funds rate no longer responded to information that affects the 10-year yield in the same way.

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Comments

[Reggie]

Cutting the Fed Funds rate is not as straightforward a solution as many think it is. First, as many realize, there is the inflation threat and the further damage to the dollar. Then there is the fact that it will probably do very little to help the housing situation.

a) 25 -50 basis points makes a very small difference in mortgage payments, if it is actually filtered through to mortgage rates
b) LIBOR has detached from its close tracking of the Fed Funds rate
c) Rates are already very low for real estate
d) Those low rates are why we are in this real estate situation in the first place!!!
e) Rates, Subprime loans, etc. are not the current problem. The problem was and is bad business practices in loan underwriting that fueled the rampant speculation to create bad debts, overbuilding, and excessive pricing of real assets. No matter how low rates are cut, the debts will still be bad, the pricing will still be excessive (and if the rates are cut, the pricing could get worse since that is what ignited them in the first place), and the oversupply is still there, and will be there until pricing comes down to the point where those who have not bought can afford to do so in the then current mortgage environment under the current terms (which will be more stringent then the recent past).

Therein is the conundrum, where if you cut rates you will raise prices, and if you raise prices you will have a problem eliminating excess supply. There will still be oversupply in housing. I would like those who don't agree to listen carefully, if there is brown @%#$&! in the bottled water of your local supermarket, it doesn't matter how low the supermarket discounts the water, that brown !$@#$# is still in it. It doesn't get any less brown, or any less stinky because the water is cheaper. Now, some may be tempted to buy that @#$@%@ at a certain price, but...