Bond Yields Are Not Particularly Low, Conditional On NGDP Growth

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Matt O'Brien has a good article on low bond yields, in the Washington Post:

Bond yields aren't always the most exciting thing in the world, but they are right now.

In fact, you'll probably be telling your grandkids about them one day. That's because the yield on the benchmark 10-year U.S. Treasury bond plunged to an all-time low of 1.37 percent on Tuesday. Not only that, but it's done so at a time when unemployment is a relatively normal 4.7 percent. This isn't, to say the least, what's supposed to happen. But it is what's happening, here and everywhere else, because the world economy is turning Japanese. Which, as we'll get to in a minute, means that future generations might have a harder time believing that rates were ever this high rather than this low.

Let's compare bond yields to a previous period when unemployment was this low, the first quarter of 2006 (which was the peak of the housing boom). In February 2006, 10-year bond yields were about 4.55%, more than 300 basis points above the current level. So why are bond yields now so low?

Everything is relative. Most of us were taught that nominal variables don't matter; you need to look at real variables. With interest rates you need to normalize by subtracting NGDP growth. Back in the first quarter of 2006, NGDP had grown at a 6.51% over the previous 4 quarters. The most recent data shows a 3.29% growth over the past 4 quarters. So NGDP growth has slowed by over 300 basis points. Hmm, does that sound familiar?

To be fair, by 2006 interest rates were already pretty low by historical standards. In the distant past the 10-year bond yield was often closer to the NGDP growth rate. By the early 2000s, however, we were already in the new world of low interest rates. The declines since then reflect slower NGDP growth, nothing more. If you want higher interest rates, ask the Fed to give us higher NGDP growth. It's that simple.

The rest of the world has only made this more true. That's because zero interest rates in one country exert a kind of gravitational pull on interest rates in another. They're "contagious," as economists Gauti Eggertsson, Neil Mehrotra, Sanjay Singh and Larry Summers put it. Here's why: if you have zero interest rates and are expected to for a while, then capital will flow into my economy every time I even consider raising my own. Money, after all, moves to where it thinks it can get the best return. But on a less happy note, this will push my currency up so much that my exports will start to lose competitiveness. And that, in turn, will slow my economy down enough that I won't actually have to raise rates. Instead, I'll keep them around zero - just like yours. The same kind of thing happens any time there's any financial turbulence in the world. Investors stampede into the safe haven that is U.S. government debt, pushing down yields and pushing out expectations of rate hikes.

If you try to raise rates with a tight money policy, it will fail for the reasons outlined in Eggertsson, et al. If you try to raise interest rates with an easy money policy that raises NGDP growth up to 5%, then you will succeed.

The yield on the 10-year U.S. Treasury bond has fallen 0.3 percentage points since Britain voted to leave the European Union two weeks ago, and almost a full percentage point since the Fed raised rates last December.

Last December, there was a vigorous debate between those who wanted the Fed to raise rates because low rates could lead to asset price bubbles, and those of us who said that argument was wrong. Can we now all agree that those who favored raising rates because a low rate environment could lead to excessive risk taking were wrong?

Put aside the question of whether low rates lead to asset price bubbles, the entire premise of the argument was that the Fed's action would lead to higher rates over time. We now know that this was false, longer term rates are far lower than in December, as are expected future short-term rates.

The paradox is that the economy can only handle higher rates if the Fed says it won't raise them. Anything else will create so much turmoil that the Fed won't even be able to pretend it's going to increase interest rates as much as it was before. That's why long-term rates actually fell after the Fed raised short-term rates at the end of last year.

If you want peace, prepare for war.

If you want to be happy, don't try to be happy.

If you want higher interest rates, tell the Fed to cut interest rates.

When Janet Yellen retires, how about appointing a Zen Master to chair the Fed? (I propose Nick Rowe.)

PS: I was recently interviewed by the French magazine Atlantico.

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