Yield curve rotations, monetary shocks, and Greenspan’s Conundrum

Abstract

Between June 2004 and December 2005 the Federal Reserve conducted a relatively aggressive contractionary policy that saw a steady increase in the effective federal funds rate of over300 basis points. Yet the 10-year treasury rate fluctuated little over 60 basis points and ultimately declined slightly over the period. This was dubbed Greenspan’s Conundrum after a famous speech by the former chairperson in February 2005. This highlights the importance of understanding the efficacy with which the central bank may impact term premia through changes in the short-term rate. I find hikes in interest rates lead to reductions in rate spreads at first, before turning positive roughly about a year post shock. These findings are statistically significant for a variety of interest rate spreads over two different samples. Following a contractionary monetary policy action, the yield curve experiences a clockwise tilt at first and an eventual counterclockwise rotation after some delay. A counterfactual analysis suggests that augmenting the federal funds rate hike of 2004 with a similar action to the Fed’s 2011 Operation Twist—but conducive to contraction rather than expansion—could have mitigated Greenspan’s Conundrum of 2004–2005.

Keywords

• Structural Vector Autoregressions (SVARs)| sign restrictions| yield curve| Greenspan’s Conundrum| Operation Twist| unexpected monetary policy shocks