randall s kroszner : why are yield curves so flat and long rates so low globally? remarks by mr randall s kroszner, member of the board of governors of the us federal reserve system, at the bankers'association for finance and trade, new york, new york, 15 june 2006. * * * today i want to talk about some new and exciting developments in bond markets around the world. the motivation for my discussion is the current puzzling situation of a relatively flat yield curve combined with relatively low real and nominal long - term interest rates, which has occurred both in developed economies and in emerging markets. i will explore some possible explanations for the pattern and will focus on changes in the prospects for and risks to the long - term inflation outlook, particularly in emerging - market economies. in particular, i will highlight how financial innovations and international competitive pressures, combined with a better public understanding of the costs of inflation and changes in the institutions of central banking, have helped improve the credibility of central banks and inflation outcomes in many emerging markets. until recently, many emerging - market countries simply did not have a yield curve because there was effectively no market for debt issued in domestic currency beyond a very short horizon. the credibility of central banks has been crucial to this deepening of the domestic capital market, which is typically associated with higher economic growth. i am optimistic that these developments will continue, as i believe that the move toward low inflation rates reflects important technological and institutional factors that are likely to persist. nevertheless, there are still risks, which underscore the importance of continuing to reap the benefits of improved central bank behavior and credibility in emerging markets and around the world. global developments in the bond market in february 2005, former federal reserve board chairman alan greenspan noted a puzzle in the u. s. economy related to the slope of the yield curve and the level of the long - term interest rate. 1 longterm interest rates had remained low and stable despite a solid economic recovery and a sustained period of monetary policy tightening during which the target federal funds rate went from 1 percent to 2 - 1 / 2 percent. when he first publicly noted this " conundrum, " as he called it, the ten - year treasury yield was just over 4 percent. today, despite an additional 250 basis points of increase in the target federal funds rate, the nominal ten - year treasury yield is roughly 5 percent, still very low by historical standards, compared to an average of more than 7

- 1 / 2 percent since 1980. the combination of a rising short rate and a relatively stable long rate has led to a very flat yield curve. during the last quarter - century, for example, the difference between the yield on the ten - year treasury note and the yield on the three - month treasury bill has been roughly 1 - 3 / 4 percent ( or, to be exact, 179 basis points from 1980 to the present ). during the last year, that difference has been less than 50 basis points and is currently less than half of that. thus, this essentially flat slope is atypical in u. s. experience. i am sure that you are all familiar with the simple relationship between short - term and long - term interest rates. the yield on a ten - year bond, for instance, can be thought of as a series of consecutive forward rates. if you could borrow and lend at the same rate as the u. s. treasury, then you could lock in a three - month loan ten years from now by borrowing for ten years and three months and simultaneously lending the same principal for ten years. the difference between the interest you pay and the interest you earn on this transaction determines the implied forward rate ten years from today. the forward rate reflects not only the market expectation of the future short - term interest rate alan greenspan ( 2005 ), statement before the senate committee on banking, housing, and urban affairs, presenting the federal reserve board ’ s " monetary policy report to the congress, " february 16. strictly speaking, this calculation requires the use of zero - coupon bonds, but it can be approximated using coupon securities. but also a " term premium " to compensate for the risk in committing to extend credit so far in the future, including the risk of future inflation. 3 at any point in time, then, we can calculate the short - term forward rate ten years ahead based on the yield curve of u. s. treasury coupon securities. 4 this " far forward " rate makes the conundrum even more puzzling because it reached historically low levels of almost 4 - 1 / 4 percent last year, more than 200 basis points below its average since 1990, and has rebounded only somewhat this year. in real terms, the far forward rate calculated from inflation - indexed securities is similarly below its long run average. the u. s. bond market conundrum has occurred in parallel with similar developments in foreign bond markets. in major industrial countries