But, as we all know, long-term rates have actually fallen as the FOMC has raised short-term rates. For example, the benchmark ten-year Treasury rate is down by more than ½ percentage point since the funds rate started heading up in the middle of last year. This is the basis for what Chairman Greenspan has called the bond rate “conundrum” that has commanded so much attention recently. There is a debate about how to interpret the decline in longer term yields and it essentially boils down to whether the surprising behavior of long rates is due to various “special factors” operating  independently of the current business cycle or instead augurs bad economic news on the horizon. If special factors are holding down long term yields, then the total amount of stimulus to spending from interest rates is currently greater than would be surmised on the basis of the current federal funds rate. In effect, unusually low long-term bond rates are now providing extra stimulus to offset the drags I described. A number of “special factors” might be at work to flatten the yield curve. One possibility is that low bond rates reflect a drop in risk premiums because inflation has become better anchored and the volatility of the real economy has fallen. But let me also note that other factors would seem to work in the opposite direction—for example, our large and growing federal budget and trade imbalances could be raising risk premiums.
Another possibility is that low long-term rates reflect unusually strong demand for long-term securities, for example, by pension funds seeking to improve the match between the durations of their assets and liabilities, by holders of mortgage-backed securities seeking to maintain the durations of their portfolios, or by foreign central banks that have been acquiring dollars. China may have been playing an especially large role, as its central bank has intervened in foreign exchange markets to peg the renminbi at a low level against the dollar. Of course, last week the People’s Bank of China announced that it had revalued the renminbi against the dollar by 2.1 percent, with the stated intention of managing the renminbi’s exchange value against an unspecified currency basket. This is not a large revaluation, but some observers think that it is the beginning of a much bigger move over time. If this is the case, we may gain a better understanding of the impact, if any, that Chinese exchange rate policy has had on U.S. bond rates. An alternative to “special factors” as an explanation for the low level of long-term yields is the possibility that the flat yield curve reflects the market’s assessment that bad news is on the horizon. In other words, investors may expect only modest increases in the funds rate in the future because they think that the drags I’ve described will keep demand on the weak side for some time to come.