Further Evidence on Greenspan’s Conundrum

Abstract

During his February 2005 congressional testimony, Alan Greenspan identified what he termed a conundrum. Despite the fact that the Federal Open Market Committee (FOMC) had increased the federal funds rate 150 basis points since June 2004, the 10-year Treasury yield remained essentially unchanged. Greenspan considered several explanations for his observation but rejected each. Thornton (2018) showed that the relationship between the 10-year Treasury yield and the federal funds rate changed in the late 1980s, many years prior to Greenspan's observation. Moreover, he showed that the relationship changed because the FOMC began using the federal funds rate as its policy instrument. The federal funds rate moved only when the FOMC changed its target for it, while, in contrast, the 10-year Treasury yield continued to respond to news as before. As a consequence of this change in the FOMC's operating procedure, the correlation between changes in the funds rate and the 10-year Treasury yield declined—effectively to zero. There is no obvious reason that the U.S. experience should be unique. Hence, we explore the experiences of two other countries that implemented a policy of targeting a short-term rate. We find that, as in the United States, the correlation between the policy rate and the long-term sovereign bond yield declined effectively to zero for both the Bank of England and the Reserve Bank of New Zealand after they began using a short-term rate as their policy instrument.

Introduction

During his February 2005 congressional testimony, Alan Greenspan noted that despite the fact that the Federal Open Market Committee (FOMC) had increased the federal funds rate 150 basis points since June 2004, the 10-year Treasury yield remained essentially unchanged. He posited several possible explanations for what he believed was the aberrant behavior of long-term Treasury yields. Rejecting each in turn, he called it a conundrum.

Not surprisingly, Greenspan's observation and ruminations stimulated much research. Several researchers (Backus and Wright, 2007; Kim and Wright, 2005; Rosenberg, 2007; Rudebusch and Wu, 2007; and Smith and Taylor, 2009) investigated possible changes in the 10-year yield. Each of these articles generated declining estimates of the 10-year Treasury term premium; however, none were able to explain why the term premium declined. Thus, the apparent aberrant behavior of the 10-year Treasury yield remained a conundrum.

Thornton (2018) took a different approach. Rather than assuming the conundrum began at about the time Greenspan observed it, he investigated when it began. He found that the relationship between the 10-year Treasury yield and the federal funds rate changed in the late 1980s, with the most likely date being May 1988. Based on previous research, he hypothesized that the change in behavior occurred when the FOMC began using the federal funds rate as its policy instrument. Once the FOMC began this practice, the federal funds rate moved only when the FOMC changed its target for it. In contrast, the 10-year Treasury yield continued to respond to news as before. The correlation between the federal funds rate and the 10-year Treasury yield declined to zero. This is because the FOMC changed its target for the funds rate infrequently. Thornton (2018) called this the funds-rate-targeting hypothesis (FRTH).

This research is motivated by the fact that if the FRTH is correct, other central banks should have had a substantial decline in the correlation between their policy rate and sovereign long-term bond yield when they began using a short-term rate as their policy instrument. Simply stated, the experiences of other countries adopting interest rate targeting should be similar to that of the United States. This article examines the experiences of the Bank of England (BOE) and of the Reserve Bank of New Zealand (RBNZ). We use these countries because they implemented a policy of targeting a short-term rate as their policy rate, and we have sufficient data to see whether their experiences are comparable with that of the United States.