Yesterday, in my post “Fed’s hidden strategy: Implementing new dual NGDP targets”, I introduced a weekly NGDP growth proxy for the United States and proposed a medium-term NGDP target rule.
Today, I want to push this analysis further by exploring how the US yield curve might be functioning as a policy instrument in the Federal Reserve’s implicit NGDP targeting strategy.
Recapping Yesterday’s Insights on US Monetary Policy
Before we go into today’s analysis of the US economy, let’s quickly recap the key points from yesterday:
- We introduced a weekly US NGDP growth proxy combining market expectations for US 5-year-5-year forward inflation and the Weekly Economic Indicator (WEI) from the Federal Reserve Bank of New York.
- We proposed a medium-term NGDP target rule for the US: n_target_t = n* – λ(n_MA_t-2 – n), where n is 4.5% and λ is 0.75.
- We observed that the Federal Reserve seems to have been implicitly following a rule similar to our proposed medium-term NGDP target rule, especially since 2022.
The US Yield Curve as a Policy Instrument
Today, I want to propose a new perspective: what if the US yield curve itself is functioning as a policy instrument in the Fed’s implicit NGDP targeting strategy? Here’s how I’m thinking about it:
The Federal Reserve directly controls the short end of the US yield curve through its setting of the federal funds rate (effectively by controlling the money base). By doing so, it influences the entire US yield curve, which in turn affects US economic activity and, consequently, US NGDP growth. Furthermore, the long end of the curve is at least partly a reflection of long-term NGDP growth (the Fed’s implicit long term NGDP target).
Empirical Evidence: The US Yield Curve and NGDP Growth
To support our hypothesis about US monetary policy, I’ve conducted some preliminary analysis, focusing on the period from 1985 to the present. This timeframe is particularly significant as it marks the beginning of what economists call the Great Moderation – a period of reduced macroeconomic volatility in the US that many attribute to improved Federal Reserve policy.
Let’s examine the following scatter plot of US data:
This graph illustrates the relationship between the US yield curve (specifically, the spread between 10-year and 2-year US Treasury yields, T10Y2Y) and the residuals of US NGDP growth from our medium-term target. Here are the key observations:
- Optimal Lag: The analysis reveals that the US yield curve lagged by 9 months has the strongest correlation with US NGDP growth residuals. This suggests that changes in the US yield curve precede changes in US NGDP growth by about three quarters.
- Negative Correlation: The regression line (y = -2.61x + 3.41) shows a clear negative relationship between the US yield curve spread and US NGDP growth residuals.
- Explanatory Power: With an R² value of 0.50, the US yield curve explains about half of the variation in US NGDP growth residuals. This is a significant finding, suggesting that the yield curve indeed plays a crucial role in the Federal Reserve’s implicit NGDP targeting.
Interpreting the Results in the Context of US Monetary Policy History
As a market monetarist, I’m not surprised that the US financial market, represented here by the yield curve, provides such valuable information about future US NGDP growth. But what’s particularly intriguing is how these results align with our understanding of post-1985 US monetary policy.
The period we’ve analyzed, starting from 1985, coincides with what my friend Bob Hetzel has termed the Federal Reserve’s “Lean-Against-the-Wind (LAW) with credibility” monetary standard.
This approach, which emerged during the Great Moderation, represents a shift towards more rule-based monetary policy in the US.
Our findings suggest that this policy framework has remained largely intact, despite significant challenges:
- Monetary Policy Response: When there’s a negative shock to US NGDP growth, the Fed responds by cutting rates. This action causes the US yield curve to steepen (higher T10Y2Y spread). Over the coming 9 months, this steeper yield curve contributes to a pickup in US NGDP growth, bringing it back towards the target. This mechanism aligns perfectly with the LAW approach.
- Predictive Power: The 9-month lag we observe in our US data aligns remarkably well with Milton Friedman’s observations about the US economy. Friedman often spoke of a lag period of around 9 months from changes in US monetary policy to the impact on nominal demand (NGDP growth). This consistency adds credibility to our findings and underscores the importance of forward-looking monetary policy for the US economy.
- “Automatic Stabilizer”: The negative relationship we see in the data suggests that the US yield curve acts as an automatic stabilizer for US NGDP growth. When NGDP growth falls below target, the Fed’s response steepens the yield curve, which then works to bring NGDP growth back up. Conversely, when US NGDP growth is above target, the flattening or inversion of the yield curve helps to moderate growth. This stabilizing effect is a hallmark of the Great Moderation period in the US and reflects the credibility aspect of the Fed’s LAW policy.
- Policy Continuity: Perhaps most importantly, our analysis indicates that despite significant policy mistakes in 2008-9 and 2020-21, the overall US monetary policy framework remains broadly the same and maintains its credibility. This suggests a remarkable resilience in the Federal Reserve’s approach to monetary policy over the past four decades.
The Federal Reserve’s Challenge: Forward-Looking Policy in a Credible Framework
The key challenge for the Federal Reserve, highlighted by our analysis of the US economy, is to control the US yield curve approximately 9 months (give or take a few months) before the desired impact on US NGDP growth.
This underscores a fundamental tenet of market monetarism and aligns with the forward-looking nature of the LAW policy: US monetary policy must be forward-looking.
The Fed needs to set policy today based on where it wants US NGDP growth to be in about 9 months. This is no easy task, but our analysis suggests that by carefully managing the US yield curve, the Fed can indeed influence future US NGDP growth in a predictable manner.
This 9-month lag also emphasizes the importance of the Fed avoiding policy errors.
A mistake in yield curve management could have consequences that only become fully apparent after a significant delay, potentially leading to undesired fluctuations in US NGDP growth.
However, the overall stability we observe suggests that the Fed has, by and large, managed to navigate this challenge successfully for the US economy since 1985. Hence, we can likely talk about a rather robust monetary standard despite the obvious policy blunders in 2008-09 and 2020-21.
Refined Policy Rule for the US
Given these empirical findings about the US economy, we can refine our proposed policy rule:
This formulation captures the lagged relationship we observed and the negative correlation between the US yield curve and US NGDP growth residuals.
Conclusion: The Enduring Legacy of Rule-Based Monetary Policy in the US
Our analysis strongly supports the market monetarist view that US financial markets provide crucial information about future US economic conditions. The US yield curve, in particular, seems to be a powerful predictor of future US NGDP growth.
Moreover, it appears that the Federal Reserve has been implicitly using the yield curve as a policy instrument to target US NGDP growth, consistent with Hetzel’s characterization of the post-1985 US monetary standard. This aligns with our long-standing argument that NGDP targeting is a superior framework for US monetary policy.
What’s particularly encouraging is the resilience of this framework. Despite significant economic shocks and occasional policy missteps, the fundamental approach has remained intact and credible. This suggests that the benefits of rule-based monetary policy, which contributed to the Great Moderation in the US, continue to provide a strongly stabilizing force in the US economy.
The challenge for the Federal Reserve going forward is to explicitly recognize and refine this implicit NGDP targeting approach for the US economy. By formalizing its use of the yield curve and market signals, the Fed could potentially enhance its policy outcomes and communication, further cementing the gains of the past four decades in US economic stability.
PS The Yield Curve: A Robust Indicator Amidst Structural Changes
Our focus on the yield curve spread, rather than absolute interest rates, offers a key advantage: it sidesteps the challenge of estimating the natural interest rate (r*), a concept dating back to Knut Wicksell. While r* may fluctuate due to structural economic changes, the yield curve spread remains a reliable indicator of monetary policy stance.
This approach aligns with market monetarist principles, emphasizing market signals over unobservable variables. It suggests our findings on the relationship between the yield curve and future NGDP growth are robust to economic evolution.
Ultimately, the yield curve provides the Federal Reserve with a dependable tool for assessing monetary policy and its potential impact on NGDP growth, even as the underlying economic structure shifts.
Note: The drawing above is created based on the article above by ChatGPT/DALL-E.
Are you interested in my new AI and data venture, PAICE? Then have a look here and here.