Once upon a time there was a systemically important central bank with lots of US treasuries and mortgage bonds, car-, student- and credit card debt and other ABS-stuff on its balance sheet (some 4500 billion dollars) and the federal funds rate almost at the so-called zero lower bound (ZLB). With GDP at its potential level in the US, unemployment probably below NAIRU and inflation expectations rising, the central bank decided to think about how to normalise the monetary policy stance again. What will this imply for the yield curve in general?
Given the state of the US economy and the intentions of the Trump administration to induce more spending in the US economy, inflation expectations will go probably even higher, and the FED will have to counterbalance this by shifting the yield curve vertically upwards. Let’s consider how this might happen.
Now, it is straightforward that the central bank sets the short-end interest rate corridor by for example setting a bid/ask -spread for borrowing and lending vis-a-vis the banking sector. Remember that central bank has unlimited amounts of central bank money at its disposal. Buying stuff (i.e. bonds) is also easy: just credit the banks’ accounts at the central bank. Selling bonds is easy as well, debit the banks’ accounts. Buying bonds from the banks does not however increase what we call “money”, as the central bank just credits bank’s checkings account at the central bank. But the yield curve for sure has changed since 2007, and this of course encourages bank lending.
How are long term interest rates determined in the ‘market’ ? For the last 8 years one could say its trivial, they are determined by the central banks. Central banks’ huge demand drives up bond prices and therefore lowers the yields across the board. In theory, the yield curve is easiest to grasp starting from the short end. The canonical theory says that the pure expectations hypothesis holds: forward rates are just the expected short spot rates, so for example if one has a bond with some coupon rate and a bullet type -maturity, one can replicate the cash flow as a series of zero-coupon instruments. This then tells us that we can do (credit risk -free, like US treasuries) bond pricing by using the forward rates. What determines the forward rates: the pure expectation hypothesis says that it is the expected spot rates.
So for example, imagine we have a cash flow that is received after two years, let the spot rate on that be , therefore it should be product of the current 1-year spot rate and a forward rate as follows:
The key question is now, what determines the forward rate? According to the pure expectations hypothesis we assume
So that the forward rates are supposed to reflect expectations of short spot rates going forward.
In practice however, most likely the FED will :
- First raise its depo-rate (the interest on bank reserves), so that the truly risk free rate is acting as a floor for money market and interbank rates. This will feed into the longer end of the yield curve as well, through forward rates. It is a real floor, because nobody should be willing to lend to a risky counterparty at a lower rate. Of course the discount window rate is to be raised as well, in order to keep the corridor stable. These operations will cause the Federal funds rate (=key offical interest rate) to set somewhere in the middle of the corridor.
- Second, they will stop altogether reinvesting the maturing debt. This will diminish both the size of the balance sheet of the Fed and the general demand for long term bonds. Prices will go down, yields will go up. Of course, the FED could just go about selling outright the bonds it holds. This would have the same, albeit much stronger effect.
- Altogether, the effect is that first the yield curve flattens a bit, and ultimately also the long end will go up. This will stabilise inflation and hopefully maximize emploement at the same time.
Other things being equal, the vertical shift of the US yield curve will then shift demand into more yielding US dollar instruments, which will tend to depreciate the euro against the dollar. This will ultimately cause imports -related inflation go up in the Euro area, and ultimatelly the interest rates will have to go up here as well, in order to anchor inflation expectations in the medium term.
Summa summarum: no hyperinflation, and the FED can delever its balance sheet in an orderly fashion without causing too much turbulence in the money and bond markets.