Measuring the "credibility penalty" in bond yields

William Hester, CFA
June 2004
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What if bond traders no longer trusted the Federal Reserve's ability to fight inflation?

On the surface it seems like an untimely question. The Federal Reserve has a well-earned reputation for keeping a lid on spiraling prices. Over the last two-and-one-half decades the yearly rate of inflation has dropped from 15 percent to 2.3 percent.

Last year's brief encounter with the specter of deflation left the Fed as concerned with falling prices as it is with rising prices. To some observers, that suggests that the Fed may have reached its long-term goal of price stability.

It's a goal worth achieving. Stable prices lower the volatility of financial markets and make it easier for households and businesses to plan. Better decisions are made throughout the economy when prices aren't expected to gyrate wildly.

A tepid inflation outlook also boosts bond prices. When the risk of runaway inflation is small, investors settle with a lower yield. How much lower? Now that the faith in the Fed's ability to fight inflation is as high as it's been in at least a generation, it's the perfect time to ask.

1994 & 2004

The Fed is well aware of its reputation as an inflation fighter and the higher bond prices that go along with it. Last week, J. Alfred Broaddus Jr., president of the Fed's Richmond branch, discredited comparisons of potential bond performance this year with the rout that took place a decade ago, saying "Most importantly, in 1994 we had not established the full credibility for our low inflation strategy that I believe we have today."

It's easy to see why neither the Fed nor bond traders want to replay 1994. To slow demand growth in a tight-capacity economy, Greenspan doubled overnight interest rates from 3 percent to 6 percent in 12 months, handing bond investors their largest loss in almost 70 years.

But tighter monetary policy was followed by six years of strong growth and low inflation. Investors were quick to forgive the Fed after long-term bonds earned double-digit returns in three of the four years beginning in 1995.

This confidence - though earned for boosting rates - is similar to the faith stock investors placed in the Fed for their easing of rates. In the late 1990's, equity investors assumed that the Fed would lower rates in the face of any trouble. This 'Greenspan put' led investors to believe that there was a floor under stock prices, which increased multiples.

Credibility is not only a boon to investors. It's been an important tool for the Fed in setting policy. Bond traders have placed increasing weight on the Fed's economic analysis and outlook.

Take the current economic rebound. The pace of yearly growth in the economy has accelerated in every quarter since the beginning of 2003. But during these 15 months the 10-year bond yield never moved above 4.5 percent, partly because the Fed promised low overnight rates for a "considerable period." Lower long-term yields have encouraged mortgage refinancings, giving consumer demand more traction.

In December, when the Fed began to tell investors that rates could climb at a measurable pace because inflation was in check, traders gave the Fed the benefit of the doubt. The 10-year bond yield fell 40 basis points from December to March.

Inflation Expectations

More recently, signs of inflation are on the rise. The Consumer Price Index in April jumped to 2.3 percent year over year from 1.7 percent the month before. Even the core measure - which excludes food and energy costs - rose to 1.8 percent on a year over year basis, up from 1.1 percent in January.

Markets aren't sitting idle. The 10-year note yield increased 100 basis points since March. The last part of this move has been driven mostly by higher inflation expectations.

You can see this by looking at the two main components of a bond yield: the real rate and the forecast for inflation over the term of the bond.

The real rate is best measured by the yield on the Treasury inflation protected securities. Ten-year TIPS now yield 2 percent. Subtract this rate from the yield on nominal bonds - currently 4.75 percent for the 10-year note - for a measure of the inflation expected over the term of the bond.

This implied inflation rate now sits at 2.75 percentage points. This is its highest level since the US Treasury began issuing the inflation indexed bonds in 1997.

That inflation expectation component of the nominal yield bounces around quite a bit, partly based on the credibility of the Fed's reputation for price stability. It's this credibility we'd like to measure. This can't be seen in the TIPS data, unfortunately, because they date back only 7 years.

Measuring Credibility

One way to estimate the Fed's credibility with bond investors historically is to subtract the most recent yearly rate of inflation from the yield on the 10-year note. The difference contains two forecasts. The first is the expected real rate over the next decade. The second is the market's estimate of the amount long-term inflation will differ from current inflation. This estimate is mostly determined by the trust the market has in the Fed for containing prices.

When the 10-year yield is much higher than the recent rate of inflation, bond investors are essentially saying that inflation threatens to increase in the future - investors lack faith in the Fed's ability to hold inflation stable, so they build a "credibility penalty" into interest rates. On the other hand, when this difference is very small, bond investors are saying that future inflation is likely to be lower than recent inflation - a sign of confidence in the Fed. The indicator is not a perfect measure of credibility because it includes the real yield, which will vary with economic conditions. But it's a long data set, and large swings in the spread are often driven by changes in the Fed's credibility, not the real yield.

Below is the average spread between the 10-year bond yield and the yearly inflation rate for each decade since 1950.

The small spread during the 1970's is notable. In the beginning of the decade investors assumed the same, modest inflation of the 1960's. Later, investors continually underestimated the speed and the extent of inflation once it arrived. They priced bonds on the belief that the high inflation rates they were seeing would be temporary.

Inflation climbed from 3.5 percent to 12 percent in the two years ending in 1974, and then from 6.5 percent to 15 percent at the end of the decade. Bond traders spent most of the decade discounting bond prices in reaction to rising inflation. By the end of the decade the average 10-year note yield was just high enough to cover the average inflation rate.

That all changed in the 1980's when Paul Volcker stepped in and delivered tough medicine to an ailing economy. Volcker raised overnight interest rates to 18 percent, while market rates moved even higher. This tightening would eventually break the back of the 1970's inflation.

With the memories of the 1970's inflation so fresh in their minds, bond traders were slow to trust Volcker's medicine. Traders kept bond yields above 10 percent for the first half of the 1980's even though the rate of inflation fell by two-thirds.

After Mr. Volcker handed the reins over to Mr. Greenspan in 1987, both inflation and bond yields continued to fall. Confidence grew in Greenspan as he guided the economy through the 1987's stock market crash, the early 1990's recession, and the Asian crisis. The spread demanded over inflation averaged 3.6 percentage points through the 1990's.

The current decade has featured continued low inflation and falling bond yields, and the spread has continued its descent. The spread currently sits at 2.2 percent, as low as it was in the tranquil 1960's.

Pricing Credibility

How valuable is the Fed's current credibility? Let's run some what-if scenarios.

One thing to keep in mind is that an increase in the rate of inflation has already been priced into nominal bonds. Based on the spread between nominal and inflation protected yields, the expected 10-year inflation rate is 2.75 percentage points, up more than 100 basis points in the past year. In May alone, 35 basis points have been added to the forecast.

But bond prices could certainly fall further, especially if the market begins to think the Fed is falling behind the curve (or if real yields climb). The 20-year average year-over-year inflation rate is 3.1 percent, about 35 basis points above the current spread. If traders priced that in immediately (while holding the real yield constant), the 10-year Treasury would fall 3 percent in price.

Over the past 50 years, inflation has averaged 4 percent, a full 125 basis points above current expectations. Boost the nominal yield by this amount and the 10-year note would lose 10 percent of its value.

Keep in mind that these are all long-term average inflation rates. Some shorter-term periods - in the 1970's inflation averaged 7 percent - would look even worse.

In the coming months bond traders will closely watch the various measures of inflation - and the Fed's comments about them. The committee members will likely be quick to acknowledge inflation pressures if they continue to appear in the data. Most important, though, is how policy makers respond to additional signs of rising prices.

Ironically, the Fed earned its inflation-fighting credibility (and the lower yields that came with it) from its role as a disciplinarian in 1994. The past 10 years have allowed the Fed to be a dependable friend of the markets, whether it was cheerleading the bubble in technology shares or keeping rates at rock bottom levels when those stocks crashed.

But if earning credibility is difficult, keeping it can be even tougher. The Fed's role as disciplinarian will likely soon be tested. Its reaction will determine investor's trust in the Fed, and that will determine the credibility penalty that investors ultimately price into long-term bonds.