Fed Policy Intent and the Term Structure

We are now all acquainted with the Fed’s effort to sculpt the term structure, the newest tool for that purpose the decision to publish the FF’s target rate.

As noted in an recent sketch, few at the Fed understand the dynamics impacting the curve. They might get lucky but eventually will get in real trouble.

To see just how much trouble they can get into, let us return to an earlier time, May 16 1994, the day before the FOMC meeting of May/17. The Fed was fighting the reverse battle then, but the example is useful nevertheless.


From our Report of May/16: “We are raising our estimate of the chances for a ½ % lift in the FF’s target from 60% to 70%.  The discount rate will follow but is of little consequence. Gov Lindsey has seen the ‘tactical advantage’ for such a lift. Our sources indicate that other policy makers may have finally come to understand that the markets, having been so thoroughly de-stabilized by recent Fed policy (or lack of), now cry out for direction. Markets ask the Fed to decisively demonstrate control, showing that it can deliver the needed discipline, as any good parent should understand is necessary.

Impact: Observers’ prediction for a ½ % lift have increased. As a result the shocking power of such a lift has diminished.  In a sense, the market is now dictating such a lift to the FOMC. On 2/4, 3/22 or 4/18 a ½ % hike would have resulted in a pronounced flattening of the curve, kicking the legs from under the inflation beast. Now, its flattening impact will be smaller. And one more lift of 1/4% will provide only irritation, steepening the curve and pushing the bond to 7.75%.

Greenspan fails to understand the fatal trap set by gradualism; he fails to understand that timidity in policy making almost always backfires. Reserves at the banks (Fed credit) have expanded through 1994 at an alarming rate because each time the FF’s target is lifted by a small increment, banks, conditioned to gradualism, increase the pace of borrowing in anticipation of the next modest lift.”


Back to the Bernanke Fed. Now Bernanke will look to flatten the curve, but not with a wallop, but with generosity.  Generosity in the short end can just as easily have the exact reverse effect. It all depends on the degree of tension in the system. Fed officials were slow learners in 1994; we see no reason to expect anything different now.

Our task then over the intermediate term will be to isolate this dynamic, and recommend to clients how best to convert policy to the bottom line.


Robert Craven