According to a couple of
recent papers from the N.Y. Federal Reserve, the magnitude of the yield curve at the end of monetary policy tightening cycles is an excellent predictor of whether or not the economy will end up in recession within 24 months following the end of the tightening cycle.
The earlier paper (Adrian and Estrella, 2009) documents the empirical result, while the later paper (Adrian, Estrella, and Shin, 2010) provides a plausible causal mechanism that has its roots in balance sheet management by financial intermediaries. The idea in (Adrian, Estrella, and Shin, 2010) is that when monetary tightening is associated with a flattening of the term spread (i.e., the gap between yields on 10 year U.S. government bonds and short-term Treasury bills becomes sufficiently small), it reduces net interest margins (NIM) for financial intermediaries. This reduction in NIM makes lending less profitable, which leads to a contraction in the supply of credit.
The plot above is slightly different than the one reproduced in both of the above papers. The difference is that I used the difference between GS10, 10-year U.S. government bonds (constant maturity), and TB3MS, 3-month T-bills (secondary market rate), to construct my yield curve.
The authors above use a constant maturity 3-month T-bill rate. I choose the secondary market rate because the data series went back further. It is possible (likely) that the secondary market rates are systematically higher than the corresponding constant maturity rates. So compared with the authors measure, my measure of the term spread is likely to be narrower.
I don't know which method of constructing the term spread is preferable...but Greg Mankiw uses the same
method! I will post my R-code (and data) for constructing the above plots soon...
This is very very interesting. Is there anything in either of the papers about inverted yield curves?
ReplyDeleteTypically (I think) inverted yield curves are seen as harbingers of recessions because they indicate that economic agents expect that interest rates are going to fall, perhaps sharply, at some point in the near future. Presumably because everyone thinks that the central bank will cut rates. Most of the literature on monetary policy seems to focus primarily on this expectations channel of monetary policy transmission.
ReplyDeleteAdrian, Estrella, and Shin (2010) think that this focus, at least for understanding the ongoing crisis, is misplaced. They focus on a more structural transmission mechanism for monetary policy: balance sheet management by financial intermediaries. If the term spread flattens, this reduces NIM, which reduces profitability of lending, which reduces the supply of credit from financial intermediaries (banks, etc).
One additional interesting observation I have is that the analysis in these papers would seem to imply that monetary policy that seeks to drive down long-term government bond yields (QE II?) might be severely counter productive...
Yeh I think you're right, but I can't really imagine that this is all there is to the story. Maybe in the decades up to the early 1990s, when financial intermediaries only made money out of spread, but the non-academic line seems to be more about the "search-for-yield" effect nowadays. In which case a flattening yield curve should indicate bubbles emerging (in which case profitability would almost definitely be a nightmare to measure).
ReplyDeletePlus, generally, I don't think we can assume that decreasing profitability in a line of business automatically reduces supply in the financial markets. Cash-flow is more important (I think) - as long as you can reinvest interest earned on a loss-making contract in some other more profitable line (eg give it to your prop desk) then no one really cares what's profitable and what's not. Most insurance lines, for example, aren't that profitable - but it doesn't stop Warren Buffett using them as cash cows and making stupid amounts of money!
You're probably right about the counter-productive nature of driving down long-term bond yields. The expression "stuck between a rock and a hard place" comes to mind!!
Rob,
ReplyDeleteIt certainly isn't quite as simple as I made it out in my post...but I really like how 1) these papers emphasize a non-expectations based channel for monetary policy transmission; and 2) they emphasize the importance of not treating the financial sector as some type of neutral pass through for monetary policy.
You have some interesting thoughts! Perhaps we should contemplate about attempting this myself.
ReplyDeleteInteresting!
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