Inflation Expectations Play Key Role In Failure Of Long-Term Interest Rates To Increase as Short Term Rates Rise: St. Louis Fed's Poole

link to speech

New York Since June 2004, the Federal Open Market Committee (FOMC) has increased the target federal funds rate every time it has met. Whats more, the federal funds futures market currently predicts that the FOMC will raise the target funds rate by another 25 basis points when it meets June 29-30. On the other hand, a key long term interest rate, the yield on 10-year U.S. Treasury securities, has not changed much, up or down, over the same period.

Since the two rates typically move in the same direction, why is the long-term rate continuing to stay basically flat? William Poole, Federal Reserve Bank of St. Louis president, said it has to do with the expectations theory of the term structure of interest rates. The essential message of that theory is that market forces should make longer-term interest rates a weighted average of the short-term interest rates expected to prevail over the life of a bond, Poole said. The simple expectations theory implies that the 10-year bond rate reflects the expected path over the next ten years of the short-term rate.

Poole's remarks were part of a speech given to the Money Marketeers, an organization aimed at improving understanding and knowledge of financial markets.

Historically, expected future nominal short rates have often fluctuated in response to changes in inflation expectations, said Poole. Over the past year, distant inflation expectations, as measured by the spread between conventional and inflation-protected bonds, have not changed markedly. Thus, we can assume that long-term expectations of inflation have remained roughly constant in the past year because of confidence in Federal Reserve policies and, in the absence of contrary information, that there is no new information about far-off real rates.

Poole said that since June 2004, while some data releases did surprise the market, over the period as a whole the data came in about as expected, contributing to the absence of a trend in the bond rate over the period. Likely FOMC responses to economic data were also known in advance, Poole said, and in the absence of economic surprises, FOMC decisions on the funds rate were much as expected. Thus, there was no particular reason over this period for the market to revise its expectations of future interest rates continuously in one direction. The bond rate fluctuated in response to arriving information, but ended up about where it started, said Poole.

Poole said recent experience is unusual but far from unprecedented. The real economy has performed very close to expectation at the beginning of 2004. The major surprise has been the large increase in energy prices. The market has interpreted this increase as a relative price change and not a sign of higher long-run inflation.

Poole said If real growth and/or inflation department significantly from current expectations, then we will see a persistent trend in the bond rate. I hope we do not see such an outcome, for I believe that the current outlook for the economy is quite favorable.

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