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Lower Bond Term Premium Stimulative (paper by FRBSF Economists Rudebusch and Swanson)

By: Steven K. Beckner

Publication date: October 19, 2006

Published in: Market News International

ST. LOUIS (MNI) - Research by senior San Francisco Federal Reserve Bank staffers concludes that the decline of term premiums and in turn bond yields has been "stimulative" of economic growth and has tended to support the case for greater monetary restraint.

Their paper, presented Thursday at a St. Louis Fed monetary policy conference, says policymakers "should always try to determine the source of the change in the term premium" to assess its economic repercussions.

But it concludes that, over the last couple of years, the decline in long-term interest rates brought about by a decline in the term premium has spurred economic growth at a time when the Fed was steadily raising short-term rates.

The paper was written by Glenn Rudebusch, director of research and top policy advisor to San Francisco Fed President Janet Yellen, San Francisco Fed economist Eric Swanson and former Fed Board staffer Brian Sack, now with Macroeconomic Advisors.

The paper cites comments from Fed Chairman Ben Bernanke and Vice Chairman Donald Kohn supporting their view that the decline in the term premium has been stimulative. This runs counter to the view of some in the market that the decline in long-term interest rates and the inversion of the yield curve presages economic weakness.

The term premium is the additional compensation that investors require for the risk of holding longer-term instruments. The yield on a bond can be divided into the expected average short-term rate over the maturity of the bond and a term premium component that reflects the compensation that bond investors demand for bearing the interest rate risk from holding long-term debt instead of short-term debt.

Bernanke, among others, has theorized that a big reason why bond yields have been so low in the face of a rising funds rate has been that various factors have driven the term premium down to historically low levels.

Those factors include a reduction in economic volatility associated with greater price stability; heavy purchases of long-term Treasury securities by Asian central banks and the related "global savings glut"; greater demand for long-term securities from pension funds; and relatively less supply of long-term debt.

Whatever the cause, Rudebusch, Swanson and Sack write that finance models "indicate that the relatively stable 10-year Treasury yield over the past couple of years reflects the fact that the rising expected future short rates that accompanied the monetary policy tighterning were offset, on balance, by a decline in the term premium."

They write that the declining term premium in long-term rates "is particularly timely and important because of the practical implications of the recent low term premium for the conduct of monetary policy."

Rudebusch et al quote Kohn's comment last year that "the decline in term premiums in the Treasury market of late may have contributed to keeping long-term interest rates relatively low and, consequently, may have supported the housing sector and consumer spending more generally."

And they quote Bernanke's statement on March 20, 2006: "To the extent that the decline in forward rates can be traced to a decline in the term premium ... the effect is financially stimulative and argues for greater monetary policy restraint, all else being equal. Specifically, if spending depends on long-term interest rates, special factors that lower the spread between short-term and long-term rates will stimulate aggregate demand. Thus, when the term premium declines, a higher short-term rate is required to obtain the long-term rate and the overall mix of financial conditions consistent with maximum sustainable employment and stable prices."

Long-term rates are only moderately higher now than when Bernanke spoke in March and until recently were a good bit lower.

Bolstering the comments of Bernanke and Kohn, Rudebusch and his co-authors write that, under this Fed "practitioner view," as they call it, "the recent fall in the term premium provided a boost to real economic activity, and, therefore, optimal monetary policy should have followed a relatively more restrictive path as a counterbalance."

The authors acknowledge that this view of the drop in the term premium is not supported by a popular New Keynesian model of aggregate output, but proceed to dispute that model. They say it improperly ignores the impact of a lower term premium on output and its monetary policy implications.

They conclude by saying that their research findings "suggest that a decline in the term premium has typically been associated with higher future GDP growth, which appears consistent with the practitioner view."

"Indeed, according to our reduced form analysis, the attention that Federal Reserve officials paid to the seemingly large decline in the term premium in 2004 and 2005 may have been justified," they add.

In presenting the paper to a group of Fed staffers, academics and journalists, Swanson said Fed policymakers were "right to closely watch the term premium" and raise short-term rates accordingly, because "the declining term premium does appear to have been stimulative over the period we looked at.

The paper stipulates that "policymakers should always try to determine the source of the change in their term premium."

"If that source can be identified, then policymakers are advised to consider the repercussions of that underlying driving force more broadly, rather than focusing exclusively on the change in the term premium," they continue. "In this way, policymakers can take into account that the change in the term premium may reflect structural shifts or disturbances
that themselves have implications for the evolution of the economy."

Swanson said the main reason for the lower term premium is probably due to the fact that "the volatility of interest rates is lower so there is less risk."

He said Asian buying of Treasury securities is less likely to be the cause because low long-term interest rates are "a global phenomenon."