Question

5. When the economy was experiencing high inflation in early 1980s, what di the Fed do to help slow down the high inflation? Explain how the Fed’s action would affect short-term rates and long-term rates of Treasury securities, and thus a possible yield curve resulting from it. What would be the likely impact of the Fed’s actions on the yield curves of U.S. Treasury and corporate bonds?

Answer 1

High inflation generally arises when there is more money in the hands of the public and fewer good available. This way there is more demand for the limited no. of goods and thus it leads to price appreciation of the goods under question and thus inflation.

Thus to control this high inflation in 1980s when unemployment rate was also in double digits, the Feb took the policy of interest rate hike. This would reduce the money supply and hence less money would chase the available low no. of goods and hence inflation would cool down. Thus interest rates were increased to constrict the money supply prevalent then.

Since the fed increased the interest rate and there was a expectation that inflation would cool down, in that scenario, the long term interest rate would reduce relative to the short term interest rate. This would leads to the yield curve flattening out.

The yields of the Long term US treasury bonds would reduce more due to the inherent safety feature which the US government provides. Since corporate bonds are not able to give the same level of safety thus their reduction would be relatively low and would also depend on the rating of the corporate bonds relative to each other and also to the US treasury securities. Similar would be the case of Short Term bonds.

However for a particular corporate bond of the same credit rating for different time durations i.e. short term and long term, the yield curve would again flatten out as in the case of the US treasury securities.