Explanation proffered for latest Fed ‘conundrum’

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Falling Treasury yields despite Federal Reserve short-term rate hikes have caused "conundrum" like that seen in 2004-2005, according to a Federal Reserve Bank of San Francisco, but unlike the earlier occasion, economists may understand it better this time.

“Evidence suggests compelling explanations — a lower ‘normal’ interest rate, the risk of persistently low inflation, and fiscal and geopolitical uncertainty — may account for the yield curve flattening,” San Francisco Fed research advisor Michael D. Bauer writes in an Economic Letter.

Determining all the factors pushing long-term Treasury yields lower may be daunting, but “data suggest the following overall picture: Long-run inflation expectations have been stable, but investors are worried about the risk of lower inflation, pushing down the inflation risk premium. Perceptions of r-star [equilibrium real interest rate] have shifted down somewhat.”

Additionally the term premium has been lowered by “changes in inflation risk and political uncertainty,” but not balance sheet normalization.

While inflation expectations and r-star perceptions normally “change gradually, but there is some risk that the unusually low term premium could suddenly rise,” Bauer writes. “In particular, perceived inflation risk could reverse its course quickly if inflation suddenly trended up. Similarly, if investors' expectations about the Fed's balance sheet were to change suddenly, or if investor sentiment about the relative attractiveness of Treasuries deteriorated for other reasons, the term premium could rise quickly. Hence there is some risk of rising Treasury yields, which some may view with concern given that high values in equity and other markets are partially based on low interest rates.”

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