Monday, August 31, 2009

The Yield Curve and Monetary Policy Regimes (fg)

This is a graphical representation taken from Benati/Goodhart 2008 (Investigating time-variation in the marginal predictive power of the yield spread) of US yield curve dynamics under three monetary policy regimes, the gold standard, the interwar period and the post WWII period. Note the different patterns of both the level and the volatility of short-and long-term interest rates. As you can see from the data, it is by no way clear that long-term bond securities yield a higher return than short-term commercial paper securities. The period of the gold standard can be characterized by a regime in which short-term rates had exhibit much reversals than their long-term counterparts. This fact might come from the gold peg of national currencies with the consequence that refinancing of financial institutions was surrounded by volatile money demand. The latter, in turn, induced turmoil in interbanking markets. Alternatively, one explanation put forward by Chicago economist John Cochrane points to the fact that both the level and the volatility of long-term rates were smoother since long-term bonds provided a hedge against real risk. Inflation risk premia had tended to be lower in the gold standard an consequently, investing in short-term securities had been much more risky than holding long-term securities. To him,
on the gold standard, long rates were, on average below short rates. Afterwards, long rates have been, on average, above short rates. If inflation is steady and real rates vary, then long-run nominal debt is safer for longrun investors. If inflation varies and real rates are steady, then rolling over short-term nominal debt is less risky for long-run investors.