In SS 6- with regards to the relation between fiscal policy and monetary policy a. If monetary policy is loose and fiscal policy is tight- it states term structure will be upward sloping (though flatter). b. If monteray policy is tight and fiscal policy is loose- it states term structure will be flat. I would like to understand this intuitively. Any thoughts. TIA.
Just remember the Fed controls the front end of the curve, and per this reading, the rear end of the curve is controlled by fiscal policy. This should make intutive sense especially for the monetary policy. Short term rates are controlled by the Fed. If the Fed is loose, they lower interest rates on the front end of the curve. If they tighten, they raise interest rates. The rear end is controlled by fiscal policy, ie a the rates of long term Treasuries are based on inflation expectations and expected growth. If the Fed is loose, the rates are low short term, so the curve can either be flat or upward sloping. If fiscal policy is also loose, growth is expected to be high, inflation expectations should be growing. This means the nominal bond will price to a higher yield. If the Fed is loose and fiscal is tight, it is the same, but not as steep. It implies that while the Fed is stimulating growth, the fiscal authority is stiffling. The yield curve will slope up but not as steep. If the Fed is tightening, but fiscal policy is loose, the front end of the curve will be higher rates, but the long end will be slightly lower rates as inflation expectations moderate. Finally, if both are tightening, the front end rates are high, and as the market expects inflation to moderate, growth to slow, the longer bonds will trade to a lower yield. The yield curve will be inverted.
Thank you- “1morelevel”.
1morelevel, excellent explanation! Can you add to it as to why loose fiscal lead to low long term IR? thanks!