Question

Outline the ways in which FED easing affects the yield curve. Is it possible for an increase in the real money supply (FED easing) to actually have exactly the opposite effect? Explain the basis of why this is or isn’t possible.

The term yield curve refers to the relationship between the short- and long-term interest rates of fixed-income securities issued by the U.S. Treasury.

Answer 1

Fed easing essentially means that the Fed increases the level of money supply in the economy by cutting the interest rates so that people are induced to spend in the economy by increasing amount of money in the hands of the public. Thus the Fed cuts the short term interest rates. This leads to yield curve turning steep as the difference between short term and long term interest rate increases. Short term interest rates are lower and long term interest rates are higher which increases the difference between them and increases the yield curve.

It is possible for an increase in the money supply to have the opposite effect, meaning the long term interest rates decline much more than the short term interests if there is a chance of a recession occurring in the near future and the government and investors don't feel that there are any signs of recovery.

Thus there is an inverted yield curve which arises because short term interest rates are higher than the long term as investors consider the near term to be risky. In order to rectify this, the Fed will have to reduce the interest rates several times as it did after March 2019. Thus even if there is increase in money supply and interest rates fall, but because of slowdown fears or the Fed not cutting the interest rates as much in order to ease investor sentiments, there could be an inverted yield curve wherein the investors fear chances of a recession and short term interest rates on bonds exceed long term interest rates as they expect the long term outlook to be poor and there is no incentive for them to hold onto the long term bonds.