Musings on the flatness of the ED curve

Yesterday Macro Man posted a couple of charts illustrating just how flat the Eurodollar curve is.  Both the front end and belly of the money market curve have flattened dramatically this year.  Should we be concerned?   Should the Fed?

In the good old days, the shape of the curve was a useful indicator and predictor of both actual and "ideal" Fed policy.   The chart below plots the 5th vs 13th Ed contracts versus both the Fed funds target rate and the rate prescribed by an inertial Taylor rule.  Although the levels do not align perfectly (nor should they, given the disparity in the level of the funds rate over the decades), the trajectory of the ED curve has done a very good job of anticipating or at worst matching shifts in actual and prescribed Fed policy.

The crisis, however, introduced a new set of monetary policy factors into the mix: QE, forward guidance, and the binding constraint of the zero lower bound.  (Which is why your author included a Taylor rule indicator to the chart- to remove that constraint.)  Unsurprisingly, the relationship doesn't look quite as cosy, but the two series have been surprisingly correlated.

To a large degree, this is an accident.   The ED curve flattened even as the Taylor rule prescription moved higher in 2011-2012 not because of an expected policy tightening (the usual implication of a move higher in the Taylor rule), but because the Fed's forward guidance explicitly crushed virtually all expectations of any tightening at all.  Thus, when Bernanke unleashed the Taper Tantrum in may 2013, the curve began to price potential policy action, re-steepening for 18 months or so even as the Taylor rule marched merrily higher, eventually trickling back into positive territory.

It was natural for a curve like the 5/13 to begin flattening at that point because of the expectation that there would be significant policy action already in the bag by the time the 5th contract rolled around.  Of course, in the ensuing period waiting for that policy action has been akin to waiting for Godot.  As a result, the curve has continued to flatten, not because of higher yields in the front leg but because of lower yields in the back leg.

To a degree, this may be rational given the debate over the decline in the long-run equilibrium funds rate.  Nevertheless, it is still problematic.  The market is pricing a little over over one rate move between now and the end of next year and just one rate move between December of next year and December of 2020.  This is very considerably less than that forecast by the blasted dot plots.  More worryingly, the curve has behaved in a manner that generally characterizes an end-of-cycle environment rather than one that is stuttering to start.

The gap between what the Fed has said on a forward looking basis and what it has actually delivered has grown so wide that the market has apparently washed its hands of the whole thing.  At this point one can very reasonably question what it is that the Fed is actually trying to accomplish with its monetary policy.  It's clearly not trying to normalize for the sake of normalization, for such a goal would not require such a pusillanimous approach.  Equally, it seems difficult to credit that the Fed is trying to maintain a steady level of accommodation; the collective progress towards its dual mandate over the past several years would appear to have warranted more than a solitary rate rise, as indeed the Fed itself has anticipated over the course of the SEP dot plots over the years.

This basic question, more than any other one, is what Yellen should tackle in her speech on Friday:  what are you trying to do?