Understanding the Term Structure of Interest Rates

The author of the article is trying to explain why the long rates are not increasing despite the Fed having raised the rate of the federal funds. Every time the Federal Open Market Committee (FOMC) holds a meeting, they increase the targeted rate of funds. William Poole notes that the long rates do not increase or decrease even in the wake of the FOMC raising the federal fund rates by 25 points. Since mid-2002, the bond rate has not been consistent, and it has kept on changing throughout the months. Between March and June 2004, the rate of a bond increased due to growth in the economy to 90 basis points. Some critics say that the decline in the long rates started in June 2004 when the Fed raised the rates. According to William Poole, this trend has been observed since mid- 2002 and not from June 2004. He says that it would have been unfair if the trend of the bond rates were to be observed from June 2004 because it had started earlier. 

The change in the long rates compared to the short rates has been caused by various issues affecting the economy of the US. According to the Fed Governor Ben Bernanke, the long rates have been affected by the “global saving glut” by the American citizens who have reduced the desire to invest. Since 2000, the rate of investment has gone down because most people want to save money. Poole explains that the “global saving glut” should not be blamed for the failure of the long rates to rise. He says the glut should not be blamed for the problem because the glut has been affecting the economy for a long time while the problem with the bond rates began in June 2004. The second reason why Poole feels that the glut should not be blamed for the decline in the long rates because it affects the interest rates while the long rates are not increasing despite the short rates increasing.

The expectations theory wants the forces of the market to impact the relationship between the short- term interest rates and the long- term interest rates. The expectations theory wants the market to set the long- term interest by considering the average of the short rates. The investor should not have to worry about the bond rate when making an investment. The expectations theory expects that the 2- quarter rate of interest should be equal to the current 1- quarter interest rate. The current market information affects the current expectations of the next 1- quarter. The expectations theory also applies to the bond rates. If we compare the last year’s 10- year old bond and this year’s, we note that there is no difference in terms of the results. It is important for the variables to respond positively to the changes in the economy so that the expectations of the future can be met. The author points out that the short- term interest rates are more flexible than the long- term interest rates. This means that the short rates are easily affected by new information and policies in the market. The short rates fluctuate in the case of inflation, unlike the long rates which are more stable. 

The author points out that there is a close relationship between the rates of bond and fund. The fund rates increase as the bond rate and vice versa. The regression coefficient between the two in the period between May 1954 and March 2005 was rated at less than 0.2 and while that of the period between January 1984 and March 2005 was more than 0.3. This shows that any change in the fund rates positively affects the bond rate. For example, if the fund rates rise by 200 basis points, the bond rate increases to 65 basis points. Despite this, in the previous year, the rate of the bond has been stagnant. It should not always be assumed that the bond rate has been affected by the fund rates. The bond rate has become flat due to the revisions of the expectations of the fund rates. The main factor that has affected the bond rate is the expectation of the future monetary policy over the years. Economists have noted that the future actions of the FOMC on the fund rates have a larger impact on the bond rate than the current actions of the FOMC on the fund rates.

According to the past economic data, it is less likely that when the short rates rise the long rates will rise too. The author tries to explain that the long- term interest rates greatly affect the economy than the short- term interest rates. Despite this fact, the long-term interest rates have a higher chance of being affected by inflation. The long- term interest rates adjust easily to new information, quite unlike the short- term interest rates. The term structure has been clearly explained by its expectations theory. The long-term interest rates have been stagnant because the expectations on the short-term interest rates have not been revised. The trend between the long-term rates and the short rates has significantly changed. The expectation is that when the short rates rise by 100 basis points, the long rates will go up by 30 basis points. This has changed over the years where the short rates increase by 100 basis points; the long rates may slightly be above or below the expected 30 basis points. Poole says that the trend of the short and the long rates are affected by new information in the market such as by the Fed Policy, inflation, and economic growth. Previously, the rate of inflation was significant as it affected the short and long rates but nowadays, it is no longer considered important. 

The recent trend in the term structure has not been a major surprise as has been noted by William Poole. The only surprise that has been experienced within the economy is with regards to the unexpected rise in the price of energy. Economists have concluded that the rise in terms of the energy prices is a normal change in the market and not a sign of high inflation. The fact that the Fed is continually increasing the rate of funds by 200 basis points shows that the monetary policy is performing well. The expectations of the Fed would be met if the market also had the same expectations as they do. It would be easy to make various changes in the policy if everything worked out according to the plan. The Fed should not be blamed for the way things have turned out with the term structure. It is not always that things turn out as they are expected to, as several factors may affect the plan in the long run. As the author concludes, he says that it is important to forecast and have expectations about future trends in the term structure, but we should also accept the errors that may be made during the forecast. He hopes that the current expectations will be met because the current trend of the economy is promising. If factors such as real growth are not considered, then we will experience a better trend in the rate of bonds. 

Reference

Poole, W. (2005). Understanding the Term Structure of Interest Rates, 87 (5), 589- 595.