Letters to the Editor Volume 2005: Issue 2


From Kevin – former student


Dr. Byrne,

I really enjoy your newsletter and I find the website easy to navigate.  While I'm waiting for the full color copy of your last newsletter to finish printing, I have a question that I have been wrestling with.  What would be the likely effect on the yield curve if the Treasury Dept. begins issuing 30-year bonds?  Is there any way you could provide a simplified answer before your next newsletter is released?






The simple answer, all else equal (ceteris paribus), is that an increase in the supply of these bonds should cause its price to fall and the interest rate to rise.  However, there must be a lot of risk management people waiting for these (the 30-year bond) to appear.  They are much better for immunization purposes than are corporate bonds of this duration.  If I were a betting person, I would try buying some of them and stripping them to bake some long duration zeros from them.


If the Fed keeps up its errant policies, you may find the short-term fed funds rate rising above the 30-year government bond rate.  There are too many ideologues on the FOMC and their staffs.  The market is trying to tell the Fed something and the Fed is not listening.  Absent oil and related prices it has dragged up, there is no serious virulent inflation.  This is a justice department anti-trust issue not a monetary policy issue.  Thank God for the federal deficit; much lower than expected by the way.


Since shorter-term rates have risen relative to the longer term rates, it also makes financial sense for the Treasury to borrower longer.  It is a rising phenomenon in Europe to go longer term. 


Good hunting! 





From Russ in Livonia, MI


The biggest driver in the inflationary spiral today is oil and natural gas. This question can deal with both, but I will isolate oil. When the Fed looks at the economy and begins evaluating their out-dated options, chief among them is their ability to impact interest rates, which, of course, tightens money supply some amount, depending on supply and demand for dollars and relative positioning in technology cycles (technology cycles refers to leaps in productivity due to the application of technological advancements).


If oil prices go up due to oil producing countries raising prices without corresponding demand, that is inflationary to our economy. If they raise it due to increases in demand elsewhere in the world (India and China, primarily), that is also inflationary but it is the old supply and demand situation which nearly always leads to prices increases (computer-related technology being a fly in that ointment). However, when those price increases lead to the inevitable price increase ripples in any industry which relies heavily on oil (transportation, plastics, etc., etc.), shouldn't the impact of those price increases on inflation be reduced by the needed pass-thru of costs. For instance, if fuel cost go up 25% for an airline, and that forces at 3% increase in ticket prices, all of which can be attributed to fuel increase, shouldn't that 3% be consider as non-inflationary. They did not raise their prices of their own free will or the need/desire for greater profitability (often they eat the increase and that is part of the problem in that industry, created by competition; good for the consumer but not so much for the company). It was purely a cost pass-thru. I realize that increases are rarely that simple, but should not the portion that this particular commodity is responsible for any increases be discounted by that amount. This would not be that difficult to do. By not doing it, it creates the ripple that runs through the entire economy, when much of this is not reality-based. Should milk prices escalating $.03/gallon be inflationary when there are many forces working on it which are far beyond their control? Should they not only be inflationary for that industry which originally has driven the cost higher?


Corollary to this, if steel prices go up 10% and auto suppliers only pass a small portion of that along to the OEMs (due mostly to the vicious negotiating techniques of the OEMs), should this not be considered deflationary, if it is not due to improvements in productivity (JIT, synchronous manufacturing, technology enhancements)?


It just seems to me that the entire way inflation is calculated creates an Inflationary Redundancy Penalty. What do you think?





Three part answer…


Part I: The Fed operates through open market operations, primarily at the short end of the market.  The only interest rate that the Fed sets administratively is the discount rate.  That is the rate the Fed charges depository institutions when they borrow reserves at the discount window facility.  Over the years, the Fed had shifted in the way in which they supply reserves to the depository system.  They have gone from supplying reserves through the discount window, to supplying them through the open market operations, which is supplying reserves by the net acquisition of U.S. Government and Federal agency securities – predominantly in the short end of the market. 


The Expectations Theory of the Term Structure of Interest Rates best explains the link between short-term interest rates and long-term interest rates, or the term structure of interest rates, the graph of which is the yield curve.    It argues the long-term interest rates (e.g. 5-year, 10-year, 20-year and 30-year U.S. Government Bonds) is the geometric average of expected yields on short-term government securities over that period of time (5-30 years, for example).  



From Dr. Byrne’s New Paradigm in Economics: 

The expectations hypothesis analysis of the term structure of interest rates argues that the current long-term interest rates are heavily influenced by the expected future short-term interest rates.  In the absence of liquidity bias, long-term (really all rates except the very shortest) interest rates are the geometric average of expected future short-term interest rates.  For example, the geometric average of 3, 4, and 6 is the cube root of their product or the cube root of 72 = 4.16.  Simply put, if the market consensus believes that short-term interest rates will rise in the future, the current long-term interest rates should be higher than the current short-term interest rates and the yield curve should slope up and to the right.  Conversely, if the market consensus believes that short-term interest rates will fall in the future, the yield curve should slope down and to the right and short-term interest rates should be higher than long-term interest rates.



Therefore, if the market expects short-term rates to rise over the next five years, the current 5-year interest rate on the U.S. government security is going to be higher than the current short-term rate (on similar risk levels of securities).  If, on the other hand, the market expects short-term rates to fall over the next five years, the current 5-year interest rate on the U.S. government security should be less than the current short-term U.S. government rate. 


An excellent source, if you’d like to research further would be to start with James Van C. Horne’s Financial Market Rates and Flows, 6th ed., Prentice Hall, 2001 (http://vig.prenhall.com/catalog/academic/product/0,1144,0130180440,00.html).


While the Fed is authorized to conduct monetary policy, its effect is pretty much confined to demand-pull types of inflation.  In this area, limited ability to produce goods and services is confronted by an excessive demand for those goods and services – this then results in excessive demand pulling up prices for those goods and services in increasingly short supply. 


As you correctly point out, Russ, the major cause of inflation right now is what we call cost-push inflation, coming from the energy sector, primarily oil.  The problem with the Fed’s policy operations in this regard is that the collateral damage is much greater than it would be in the case of demand-pull inflation.  Secondly, the Fed’s policy actions tend to have more of a shotgun effect than that of a shot from a rifle.  The danger is that you will have all collateral effect and little or no effect on the industry (oil in this case) that is the cause of the supply-side shock. 


After a year of Fed actions, the price of oil has been rising for the past few days (June 14, 2005) and it is approaching its nominal record high.  At best, the Fed policy has had no effect, and at worst, it has slowed down the economy. 


The ability of the oil industry to drive up prices is the result of the last 10-15 years where the industry has recartelized, resulting in almost no increases in capacity for production and refining, while demand has increased significantly.  While we discussed production and refining in the newsletter, similar downstream cartelization is reflected in declining number of gas stations, while at the same time, the number of cars on the road is increasing…





Between 1994 and 2002, the number of gas stations in the US declined by over 16% (from 202,878 to 170,018).  

In the same period, the number of registered number of cars rose 6.7% (from 127 million to nearly 136 million).  

The number of gas stations declined in all but eight states:  The biggest declines occurred in Louisiana = 6,277; California = 4,648; Colorado = 4,241; Pennsylvania = 3,325.






Part II: For the most part, the U.S. Bureau of Labor Statistics addresses the penalty that you refer to when they control for (isolate) various sectors of the economy.  For example, the following graph depicts the annual percentage change in overall prices compared to preceding year, the core rate (removing energy and food from the mix).  If you’d like to break down specific areas within the price indexes, go out to the U.S. Bureau of Labor Statistics website and wander around the databases (for the CPI http://bls.gov/cpi/home.htm).  








Part III: Some of what you referred to in your question regarding steel prices,” if steel prices go up 10% and auto suppliers only pass a small portion of that along to the OEMs,” was addressed when we discussed the recent change in the way that the PPI passes prices through to the CPI ((Volume 2005: Issue 1) April 29, 2005).  


From 1979 - 1999, the CPI rose higher than the PPI in 20 of 21 years.  In the five years, from 2000 - 2004, the CPI was higher than the PPI twice.  

From 1979 - 1999, the PPI has averaged 3.2% inflation and the CPI averaged 4.6%.  

In that time, a whopping 45.0% incremental inflation was passed through the CPI from producers to consumers.  

Since 2000,  there's been a sea change in the economy
The PPI  averaged 2.2% inflation over that time and CPI has averaged 2.5%.  

Only 13.4% incremental inflation has passed through from the PPI to the CPI.




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