Typically, when the Federal Open Market Committee (FOMC) raises the federal funds rate, long-term interest rates react by increasing also. However, between June 2004 and July 2006, the FOMC raised rates 17 times in 1/4 percent increments, from 1% to 5.25%, and long-term rates barely moved.
In the past, a 1% increase in the fed funds rate produced a 0.3% increase in the 10-year Treasury yield (Source: Economic Letter, September 2006). Thus, with a 4.25% increase in the fed funds rate, you would expect the 10-year Treasury yield to increase by 1.3%, but it only increased 0.3%.
Similarly, since 1980, the difference between the yield on 3-month Treasury bills and 10-year Treasury notes has averaged 1.79% (Source: The Federal Reserve Board, June 16, 2006). As recently as the end of 2006, the difference was less than 0.5%. Currently, the difference is still only 0.8% (Source: Federal Reserve Statistical Release, November 26, 2007).
Why haven't long-term interest rates increased as expected? Returns on bonds have two components - the real component, which compensates investors for the risk of loaning money, and the inflation component, which compensates investors for expected inflation over the bond's term. In recent years, both components have been trending downward:
- Real component -- The real component is also called the term premium, since historically investors have received a premium for increasing the term the bond is held. Since the mid-1980s, economic growth has been less volatile, making investors more confident about future economic stability, so they require less return to hold longer-term bonds. It is also believed that demand for long-term bonds has increased, while supply has not kept pace, bringing down returns.
- Inflation component -- Compared to a 5% inflation rate from 1980 to 1999, inflation in industrialized countries averaged 2% from 2000 to 2004 (Source: The Federal Reserve Board, June 16, 2006). Not only has inflation decreased, expectations for long-term inflation are in the 2% range. This has put significant downward pressure on long-term interest rates.
The behavior of long-term interest rates is not unique to the United States - other countries around the world have experienced similar declining patterns. The trend is so widespread that globalization of trade is supposed to be a major factor. Since goods, services, money, and ideas can cross borders so easily now, economies in different countries are tied together more closely. Excess demand in one part of the world can be filled by excess supply in another part of the world, evening out economic activity in individual countries.
This has major implications for monetary policy. Central bankers have control over short-term rates, which is the primary means of implementing monetary policy. Typically, when short-term rates are increased, long-term rates follow. Higher long-term rates reduce consumption and investment, which helps contain inflation. Reducing short-term rates typically reduces long-term rates, which increases economic activity. If those relationships no longer hold, monetary policy will be significantly impacted.