The Fed “succeeded” in flattening the yield curve

Some articles point out one “bright spot” in this dismal day—the Fed succeeded in lowering long term yields.  They also raised short term yields, making the yield curve flatter.  You might want to get out your money textbook to find out what type of monetary policy causes a flatter yield curve.  According the an article by Sharon Kozicki at the Kansas City Fed:

The yield spread reflects the stance of monetary policy. According to this view, a low yield spread reflects relatively tight monetary policy and a high yield spread reflects relatively loose monetary policy.

The yield spread is the long rate minus the short rate.  Kozicki says the conventional view is that a lower yield spread means tighter money.  Today the Fed made the yield curve flatter.  You might think; “They know what they are doing; surely they wouldn’t tighten monetary policy.  Sumner must have things backward.”

OK, how would tight money affect the dollar?  Here’s the euro/dollar (the fall means the dollar soared after 2:15, or 6:15 London time):













And here’s the Dow:










So what do you think, monetary stimulus or monetary tightening?  The only thing that’s “twisted” is the Fed’s logic.  They are so obsessed with the Keynesian low interest rate approach to stimulus that they’ve completely lost their bearings and ended up tightening monetary policy.

PS.  I forgot to mention one other piece of “good news,” the Fed action sharply reduced oil prices.  Less inflation “worries.”



52 Responses to “The Fed “succeeded” in flattening the yield curve”

  1. Gravatar of Bob Dobalina Bob Dobalina
    21. September 2011 at 13:45

    the 5y5y dropped 25bps(!) intraday.

  2. Gravatar of Benjamin Cole Benjamin Cole
    21. September 2011 at 13:45

    Very interesting commentary by Scott Sumner.

    BTW, if you want to become very nettled, read today’s lead editorial in the (paper version) WSJ. Put it this way, they actually write, “as long as we have fiat money” en route to advocating that the Fed abandon any growth targets to exclusively target only price stability.

  3. Gravatar of Steve Steve
    21. September 2011 at 13:46


    They also likely reduced business investment. Less output gap “worries.” There are two ways to close an output gap.

  4. Gravatar of marcus nunes marcus nunes
    21. September 2011 at 13:52

    “Operation Twist” had been in the pipelines for some days since Hilsenrath wrote about it. So it wasn´t even unexpected. Even so it was depressive!. Funny that the 3 Stooges (P, F & K)voted against the measure. Does that mean they wanted a more lose MP!?

  5. Gravatar of Ram Ram
    21. September 2011 at 13:57

    The 10 year TIPS spread plunged sharply the minute the statement was released. Even if you’re a New Keynesian, rather than a market monetarist, that’s tight money right there. With the FFR fixed near zero, the Fed lowering inflation expectations (and they hadn’t particularly risen much in anticipation of the announcement) spells lower AD. Sometimes, I feel like the idea of having the Fed make a statement every once in a while that’s heavily prepared is silly. Bernanke should come out and say, “this is our policy” and then if inflation expectations immediately tank and that’s not what he really wanted he can say, “no, no, you’ve got me all wrong. Yay 4% inflation for a while” or something. I find it very difficult to believe that the policy had the intended effect in light of the TIPS spread response, and yet they won’t be able to do anything about it until the next meeting. At Bernanke’s next press conference, someone should ask him, “What are you trying to do? What measurable benchmark can we judge your policies by? And if your target is 3% annual NGDP growth after the biggest NGDP collapse since WWII, what on earth are you thinking?”

  6. Gravatar of Silas Barta Silas Barta
    21. September 2011 at 14:29

    Wait, isn’t buying long-term bonds the same kind of QE that you cheered on before? Isn’t it the same thing that the Fed would do initially if they started targeting NGDP?

  7. Gravatar of Drew Drew
    21. September 2011 at 14:37

    I’d consider attributing the rise in the dollar to the Fed’s stronger negative language on the outlook of the economy. Today was a risk-off day in the markets.

  8. Gravatar of Brito Brito
    21. September 2011 at 14:45

    Now I’m confused, I thought flattening the yield curve was the whole point of unconventional monetary policy, such as how Thoma explains here:

    Now you’re saying that is contractionary?

  9. Gravatar of Mike Sandifer Mike Sandifer
    21. September 2011 at 14:45


    Again, I have you to credit for having considered this interpretation myself. I didn’t have an opinion yet about whether the Fed action today actually had this effect, or whether they had such a small effect that more trouble in Europe overwhelmed it easily. I hadn’t looked at many numbers yet.

    At the very least this policy action is woefully insufficient.

  10. Gravatar of Mike Sandifer Mike Sandifer
    21. September 2011 at 14:48


    No, as Scott’s pointed out many times, a successful monetary stimulus operation will raise the yield curve toward the long end, as markets predict recovery and eventual Fed tightening.

  11. Gravatar of Brito Brito
    21. September 2011 at 14:53

    Mike that is true, but then I’m confused further, if that is the case, from where exactly does the actual stimulus come from? I’ve always understood the mechanism to be from lower long term interest rates, since the excess reserves at the primary dealers are not lent out. But if a successful QE doesn’t lower long term interest rates, and if banks don’t lend excess reserves, what else is there?

  12. Gravatar of bill woolsey bill woolsey
    21. September 2011 at 15:01

    How is this policy contractionary?

    Look, maybe the market thought there was a chance they would lower the interest rate on reserves.

    Maybe even a slight chance that they would expand the balance sheet.

    And didn’t you just have a whiff of hope that the would start targeting nominal GDP expecations–a growth path? .01% chance.

    All we got was the twist thing, and so this was “contractinary” compared to what might have happened.

    I don’t see how changing the composition of the Fed’s balance sheet is contractionary.

    If people expect a recession in the future, this should flatten the yield curve.

    That doesn’t mean selling off short bonds offset by purchases of long bonds is contractionary.

    It might not be significant enough to have much impact. But that is about all.

    Is the Fed freeing up enough short term bonds that are near perfect substitutes for money to signicantly increase the quantity of money now?

  13. Gravatar of Brito Brito
    21. September 2011 at 15:15

    Mike I’m trying to independently work this one out. Does it have something to do with investors seeing less risk of losing money were they to invest in equities by not instead buying bonds and getting a return from their maturity value, which means the demand for long term treasuries is reduced causing yields to rise to some equilibrium rate consistent with a booming economy?

  14. Gravatar of flow5 flow5
    21. September 2011 at 15:15

    Operation twist was introduced in January 20, 1961. The FED wanted to lower long-term interest rates because the U.S. was in a recession while at the time Europe’s economies were much stronger. This magnified interest rate differentials igniting carry trade activity within Bretton Wood’s fixed exchange rate system.

    Opportunists were able to convert U.S. dollars to gold & capitalize on higher investment returns in Europe. The administration wanted to curb this excessive outflow of gold by speculators. Thus operation twist was designed to freeze the short-term rates (used by speculators), while lowering longer-dated rates (& stimulate housing).

    Bernanke’s version of “operation twist” is a “beggar thy neighbour” strategy. But flattening the yield curve does not increase the incentive for new bank lending & investing. Banks require a profitable spread between their costs & their revenues.

  15. Gravatar of Ryan Fitzgerald Ryan Fitzgerald
    21. September 2011 at 15:43

    Inflation expectations also went down after the announcement. Monetary policy fail.

  16. Gravatar of Mike Sandifer Mike Sandifer
    21. September 2011 at 15:53


    My guess is that it’s the credible willingness of the Fed to lower long rates that is important. As Scott has pointed out, if the Fed had established a consistent pattern of keeping NGDP constant and had perfect credibility, they may never have had to take any action at all to help NGDP.

    With this action today, as Scott points out, it may have been the Fed’s words that accompanied the action that may have destroyed credibility with regard to sufficiently low rates for an extended period of time.

  17. Gravatar of Brito Brito
    21. September 2011 at 16:14

    Mike, this stuff is very confusing. :S How could/why would the market think that the fed cannot credibly keep long rates low (this is why monetary policy is tight?) despite long rates being low, and having been low for a long time now?

  18. Gravatar of Mike Sandifer Mike Sandifer
    21. September 2011 at 16:29


    Just look at the evidence. Three members of the FOMC dissented during meeting over the last Fed action. That was the largest dissent in over 20 years, as I recall reading. Also, there’s some political pressure against additional Fed action, most recently in the form of that Republican letter to Congress.

    From the beginning of this crisis the Fed hasn’t done enough to meet the increased demand for money in the economy, often letting NGDP fall below even it’s normal 5% target. Recent steps are very timid, despite a developing economic emergency in the Euro zone that is sucking up dollar liquidity.

  19. Gravatar of Mik Mik
    21. September 2011 at 16:31

    Not that it matters for the purposes of this post, but Sharon Kozicki is at the Bank of Canada (Kansas Fed many years ago).

  20. Gravatar of Brito Brito
    21. September 2011 at 16:41

    Mike I agree with what you say the evidence shows, which is why I follow Scott Sumner. What I don’t get is why? Or perhaps, what I want to know is, what can the fed do to reassure markets (other than this complicated NGDP futures scheme of course), and why didn’t operation twist do that? I know that it didn’t, that’s where I agree, I just don’t understand why exactly.

  21. Gravatar of bill woolsey bill woolsey
    21. September 2011 at 16:42


    That is it.

    Bond investors sell more than the Fed buys and they use the proceeds to purchase other sorts of assets. Perhaps stocks, but if the bond holders are firms, they may purchase capital goods in order to expand capacity and meet expected higher future demand. If they are households, they may sell bonds and purchase consumer goods–maybe yachts, mansions, or limos.

  22. Gravatar of Jeff Jeff
    21. September 2011 at 16:47

    I’m not so sure this is tighter money. Selling short-term bills and buying long-term bonds does not affect the monetary base. And to the extent that it succeeds in raising short term rates, it lessens the negative impact of paying interest on reserves, provided, of course, that the IOR rate doesn’t go up too.

    There was some speculation in the financial press that the Fed might lower or eliminate IOR at this meeting. When that turned out not to be the case, that effectively did tighten money. Since inflation expectations also fell after the announcement, it appears whatever expansionary effect the twisting is expected to have is outweighed by the disappointment that nothing else was done.

  23. Gravatar of Jeff Jeff
    21. September 2011 at 16:56

    My second paragraph above is a poor imitation of Bill Woolsey’s comment above. I really should read other peoples’ comments more closely before adding my own. But at least my first paragraph made an original point.

  24. Gravatar of Brito Brito
    21. September 2011 at 17:03


    >but if the bond holders are firms, they may purchase capital goods in order to expand capacity and meet expected higher future demand.

    Why would they expect higher future demand?

  25. Gravatar of Becky Hargrove Becky Hargrove
    21. September 2011 at 17:26

    How much actually went into the 30 year notes. All I can think is that in so many countries, the banks do not have to contend with 30 year mortgages as do the U.S. banks. Might the strategy have anything to do with that?

  26. Gravatar of Scott Sumner Scott Sumner
    21. September 2011 at 18:06

    Bob, That’s amazing–do you mean nominal interest rates or inflation spreads? (It looks like both fell sharply.)

    Ben, The WSJ just couldn’t be any more clueless. TIPS spreads are plunging and they still think inflation is the main problem.

    Steve, Good point.

    Marcus, I expected it too. But I really thought the rest of the report would show some awareness of the need for something more–maybe not this meeting, but an indication that something was in the works. But the report was so clueless about what is going on. They talked about falling unemployment, even though forecast growth rates for RGDP are below 2% and falling–how does that reduce unemployment? And no discussion of other possible moves like lower IOR or level targeting. Just a big smiley face.

    Those three wanted the DOW to fall by even more than 285 points, And an even steeper fall in TIPS spreads.

    Ram, Very well put.

    Silas, No. This is not a move to increase the money supply, it’s operation twist.

    Drew, The dollar should fall on a negative outlook for the economy.

    Brito, You said;

    “Now you’re saying that is contractionary?”

    No, I’m quoting a Federal Reserve publication that says according to the standard model a flatter yield curve is a sign of tighter money.

    Mike, Yes, it’s insufficient. Just to be clear I’m not arguing that if the Fed had done nothing today, stocks wouldn’t have fallen. I think O. Twist was priced in. I think it’s the weakness of the rest of the statement that discouraged markets. But note that a flattening yield curve is associated with falling stocks and a rising dollar. So even those who don’t buy my yield curve argument need to ask themselves why the dollar rose and stocks plunged.

    Brito, QE works only by sending a signal about future monetary policy. It’s the Fed telling the markets the future money supply will also be higher–and that creates inflation expectations.

    Bill, Yes, the twist itself is not contractionary, I agree. My point is that twist is aimed at flattening the yield curve, and contractionary policies flatten the yield curve. So if other aspects of the announcement flattened the yield curve, it still shows the folly of the whole enterprise. Rooting for a flatter yield curve is like rooting for failure.

    Flow5, Beggar thy neighbor? Did you notice the dollar shot up against the euro?

    Thanks for the info Ryan.

    Thanks for clarifying that Mik,

    Jeff, I agree, the Twist itself wasn’t contractionary, it was the lack of other moves.

    Becky, I don’t know, but 30 year bond yields plunged very sharply.

  27. Gravatar of bill woolsey bill woolsey
    21. September 2011 at 18:08

    They will expect higher demand because the workers employed by other firms will be purchasing their products.

    The other firms will expect higher demand because the additional workers you hire will be purchasing their products.

    _If_ firms do not expect the policy to work, then interest rates will fall however low is necessary to raise demand. However, know that this will happen, interest rates may never fall at all but may actually rise.

    And if output cannot rise because of capacity constraints, then prices will rise, which reduces real interest rates. But that really means that people buy now because prices will be higher later.

    And that causes long term interest rates to rise too because of expected inflation.

    Again, if people thought it wouldn’t work, then interest rates would fall, and low enough to generate the desired expenditure given their current expectations. And that knowledge is what makes expectations change, so that interest rates many never fall at all.

  28. Gravatar of Staunch Staunch
    21. September 2011 at 18:11

    I think some of the negative pressure is because this whole process is going to take until June 2012.

    But I’m with Bill. I don’t see how this is contractionary. I think at best it’s too little too late. But I don’t see any downside.

    From what I understand, these purchases will be pretty much sterilized, except for the fact they are going to reinvest into the MBS (which is sort of extending QE2).

  29. Gravatar of Paul Giamatti Paul Giamatti
    21. September 2011 at 18:13

    Scott, you leave out the part of Kozicki’s paper that actually matters in this instance…”Because they reflect what market participants expect short-term yields will average over a relatively long time interval, long-term yields
    are a reasonable benchmark against which current short-term yields can be compared. Thus, when current short-term yields are high relative
    to long-term yields, so the yield spread is low,
    this view holds that the current stance of monetary policy is relatively tight.” But both short term and now long term yields are near zero!! This means the low yield spread isn’t possibly contractionary.

  30. Gravatar of Scott Sumner Scott Sumner
    21. September 2011 at 18:17

    Stauch, We know it’s contractionary, inflation expectations fell sharply. The question is why. I agree with Bill that it wasn’t Operation Twist, it was disappointment over a lack of other moves.

  31. Gravatar of Quote of the Day | The Everyday Economist Quote of the Day | The Everyday Economist
    21. September 2011 at 18:18

    […] Scott Sumner LD_AddCustomAttr("AdOpt", "1"); LD_AddCustomAttr("Origin", "other"); […]

  32. Gravatar of Steve Steve
    21. September 2011 at 18:54

    I agree it was disappointment of lack of other moves. Plus taking until June 2012 suggests other moves might not be forthcoming until then, but mostly it was lack of guidance.

    Here’s what peeves me:

    I view the “twist” intent as a sterilized liquidity enhancement strategy. The Fed is trying to push down mortgage rates without adding net money to the economy because it is acting like housing credit is the only problem.

    But it feels like the US in H1 2008, with the alphabet soup of (sterilized) liquidity programs like TAF and TALF designed to help banks get liquidity without increasing the balance sheet or raising CPI/NGDP expectations.

    It also feels like the EMU in H1 2011, with the ECB buying sovereign bonds and sterilizing them through the banking system. Again acting like the sovereigns only needed liquidity, but no monetary ease or fiscal union.

    So we have a completely recidivist Bernanke going back to the liquidity enhancing but non-easing policy steps that have already failed twice before. The central bankers just refuse to correctly diagnose the problem.

  33. Gravatar of Dan Kervick Dan Kervick
    21. September 2011 at 19:12

    We know it’s contractionary, inflation expectations fell sharply.

    A basic question: Why are lower inflation expectations contractionary? If I’m a potential lender, won’t I be more willing to lend at a low interest rate if I anticipate low inflation?

  34. Gravatar of MTD MTD
    21. September 2011 at 19:17

    The Fed has both the wrong target (low long rates) and, in this case, the wrong tool (a sterilized intervention). Didn’t the Swiss just show us what unsterilized intervention with an explicit nominal target and an open-ended commitment can do?

    I agree with Scott on the yield curve. Japan has had low long rates and a flat curve for 15 years because the BOJ has decided to preside over zero average NGDP growth. The US yield curve peaked in February and has fallen with NGDP expectations.

    As for the complete market response, I’d also note that 1) equities fell sharply, 2) TIPS spreads fell, 3) corporate bond spreads widened, 4) commodity prices fell, 5) the dollar advanced and 6) the yield curve flattened further. Fedfail indeed.

  35. Gravatar of Steve Steve
    21. September 2011 at 19:30

    I should add that if the Fed wants to lower long term rates, all it needs to do is SELL 400 billion or so of treasuries, UN-sterilized. That would get ’em the low long-term rates they crave, although no one would have any money left to take advantage. But that’s kind of the problem we already have.

    Agree with MTD. Fed is using the wrong target and the wrong economic model.

  36. Gravatar of Richard W Richard W
    21. September 2011 at 20:16

    Everything that Chairman Bernanke does has to be understood in the context of Bernanke being a creditist. Lending determines income is the Bernanke paradigm. Operation twist to lower long bond yields rather than increase the quantity of money fits within the paradigm of how he believes monetary policy is transmitted to the economy.

    Scott Sumner
    21. September 2011 at 18:06
    ” Drew, The dollar should fall on a negative outlook for the economy. ”

    A US-centric view. A negative outlook for the global economy will see the dollar appreciate. See for example the recent Fed dollar swaps. The USD has been appreciating for two weeks and there is little reason not to expect that appreciation to continue in the immediate future.

  37. Gravatar of Full Employment Hawk Full Employment Hawk
    21. September 2011 at 20:40

    “According to this view, a low yield spread reflects relatively tight monetary policy and a high yield spread reflects relatively loose monetary policy.”

    This is only an empirical regularity that held under a regieme in which the Fed did not try to affect the yield curve. We now have a regieme change to a regime under which the Fed is explicitly influencing the yield curve. Therefore the Lucas critique applies. The change in the yield curve may not imply what it did before.

  38. Gravatar of Morgan Warstler Morgan Warstler
    21. September 2011 at 21:03

    “Mike, Yes, it’s insufficient. Just to be clear I’m not arguing that if the Fed had done nothing today, stocks wouldn’t have fallen. I think O. Twist was priced in. I think it’s the weakness of the rest of the statement that discouraged markets. But note that a flattening yield curve is associated with falling stocks and a rising dollar. So even those who don’t buy my yield curve argument need to ask themselves why the dollar rose and stocks plunged.”

    never reason from a price change.

  39. Gravatar of K K
    21. September 2011 at 21:04

    Bill Woolsey: “How is this policy contractionary?”

    If they take a negative beta asset out of the economy (which they did), people need to sell high beta assets (stocks) to rebalance their portfolios (which they did). Twist is *contractionary*. STOP BUYING BONDS!!!!!

  40. Gravatar of K K
    21. September 2011 at 21:11

    What this proves is that the market wants more, *not less*, bonds. More bonds are *stimulative*. And the Fed is now officially out of options. It’s time for treasury/congress to step up and start giving the market some more of that portfolio hedge it’s desperately crying out for.

  41. Gravatar of FT Alphaville » The not-so-fearless Fed? FT Alphaville » The not-so-fearless Fed?
    22. September 2011 at 00:08

    […] Sumner points out that a flat yield curve is typically seen as a result of tight monetary policy. He quotes Sharon […]

  42. Gravatar of Charles R. Williams Charles R. Williams
    22. September 2011 at 03:21

    This policy will do nothing at all beyond momentarily creating market waves. You cannot cause a tsunami in Japan by throwing bricks in San Francisco Bay. The fed is tinkering with the maturity of US govt liabilities. If treasury does not offset it, then private sector financial intermediation will offset it. This is the illusion of action. Apparently, Bernanke thinks he will succeed by magic tricks in stimulating some beneficial action on somebody’s part.

  43. Gravatar of Joe2 Joe2
    22. September 2011 at 03:52

    And Scott, the Australian dollar has fallen like a rock. The aussie is a pretty decent indicator for global liquidity/monetary tightness/looseness.

  44. Gravatar of bill woolsey bill woolsey
    22. September 2011 at 04:05

    They sold stocks and did what? Held more money in their checkable deposit?

    Why not buy the short term bonds?

  45. Gravatar of K K
    22. September 2011 at 04:27

    Bill: Of course they didn’t net sell stocks. But they would’ve if they could’ve at the old price. Instead the price of stocks went down by 3%. So now they have the right amount of stock (3% less) for their reduced bond holdings. Total fail!

    Charles R. Williams: “If treasury does not offset it, then private sector financial intermediation will offset it.”

    Well, that would be the point! What they want is for the private sector to create new risk assets and invest. Unfortunately, the private sector is currently unable to replicate the super-safe super-liquid securities that are government bonds. Even high grade corporate bonds have too much credit spread and are comparably illiquid by several orders of magnitude. And the market *wants* government bonds, so the Fed is damaging investor portfolios by withdrawing them. If they want to help they need to buy the securities the market *doesn’t* want. If they buy enough of them, the market might even create more of them which just might be stimulative.

  46. Gravatar of K K
    22. September 2011 at 04:40

    Bill: “Why not buy the short term bonds?”

    They did. But those bonds are less negative beta than the ones they had. So now they want to hold less stock at the old price. And so, they do.

    CAPM rarely tells you anything very precise about portfolio allocation due to a variety of imperfections. But the negative beta (suitability as a hedge) in this case is so big and obvious that the impact on portfolio optimization is huge.

  47. Gravatar of Joe2 Joe2
    22. September 2011 at 05:02

    Scott is right. This is what we learned in beginners economics and talked about on trading desks. A flattening yield curve is a tightening. They are attempting to shift the yield curve from a slightly normal curve to a flatter one.

    The Fed has gone bonkers.

  48. Gravatar of W. Peden W. Peden
    22. September 2011 at 05:21


    “The Fed has gone bonkers.”

    Let’s not overstate its sanity in the past, but yes: this seems nuts. I have absolutely no idea why anyone has been talking about Operation Twist in the first place.

  49. Gravatar of Jon Jon
    22. September 2011 at 05:22

    Usually a flattening signal a tight policy because the long end of the curve is fairly stable but the short-end gets jerked around by the Fed. They pull the short-end down and steepen the curve when loose and then pull the short-end up and flatten the curve when tight.

    But this is just one of many possible stories.

  50. Gravatar of johnleemk johnleemk
    22. September 2011 at 05:50

    One of the ETFs I hold fell about 10%. The Fed really has lost its mind.

  51. Gravatar of Drew Drew
    22. September 2011 at 07:17


    I disagree that the dollar should fall due to a weak US economic outlook. The past few years have shown that when the US economic outlook weakens, the dollar and other “risk-off” assets like bonds appreciate in value, while riskier assets like stocks fall. It may be counter-intuitive from an economic point of view, but from an asset allocation perspective it makes perfect sense.

  52. Gravatar of Scott Sumner Scott Sumner
    22. September 2011 at 07:31

    Paul, Low interest rates don’t mean easy money–that’s a common mistake. But the point is that the yield spread fell. Regardless of whether you think money is easy or tight, it just got tighter.

    Steve, Deep down I think Bernanke knows we need some sort of level targeting, he’s just not willing to go out on a limb. I agree with your comment.

    They seem determined to replicate the Japanese yield curve, but how did that work for Japan?

    Dan, You are confusing money and credit. In any case, borrowers will be less willing to borrow. But falling AD isn’t caused by unwillingness to lend, it’s caused by tight money.

    MTD and Steve, I agree.

    Richard, The outlook for the global economy didn’t suddenly get less rosy at 2:15 except to the extent that the Fed tightened monetary policy, i.e. reduced NGDP expectations.

    FEH, Maybe, but Bernanke better hope he’s right and all the markets are wrong.

    Morgan, That cliche doesn’t answer my question.

    Charles, Worse than nothing, the lack of action makes things much worse.

    Joe2, Good point.

    Bill, I assume short rates went up a bit because the Fed is going to sell a ton of T-bills. Am I wrong?

    I agree with the other comments–running out of time.

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