December is fast approaching. No, not December 25^th, December 16^th! Yes folks that is the date of the next FOMC rate decision. What makes this FOMC meeting special is the Fed might actually raise the Fed Funds Rate (albeit modestly). The minutes of the October FOMC meeting clearly indicated that, barring a significant negative event, the Fed is likely to finally “lift off.” Following the release of the minutes, last Wednesday, yields of long dated U.S. Treasuries headed lower.           

Stop rubbing your eyes. You read correctly. The yield of the 10-year U.S. Treasury note and the yield of the 30-year government bond dropped following the release of the FOMC minutes. Why did long rates decline when the Fed will probably begin tightening in December? The answers could be found in the opening paragraphs of the FOMC minutes:

“The staff presented several briefings regarding the concept of an equilibrium real interest rate–sometimes labeled the “neutral” or “natural” real interest rate, or “r*”–that can serve as a benchmark to help gauge the stance of monetary policy. Various concepts of r* were discussed. According to one definition, short-run r* is the level of the real short-term interest rate that, if obtained currently, would result in the economy operating at full employment or, in some simple models of the economy, at full employment and price stability. The staff summarized the behavior of estimates of the short-run equilibrium real rate over recent business cycles as well as longer-run trends in real interest rates and key factors that influence those trends. Estimates derived using a variety of empirical models of the U.S. economy and a range of econometric techniques indicated that short-run r* fell sharply with the onset of the 2008-09 financial crisis and recession, quite likely to negative levels. Short-run r* was estimated to have recovered only partially and to be close to zero currently, still well below levels that prevailed during recent economic expansions when the unemployment rate was close to estimates of its longer-run normal level.” 

“With respect to longer-run trends, the staff noted that multiyear averages of short-term real interest rates had been declining not only in the United States, but also in many other large economies for the past quarter-century and stood near zero in most of those economies. Moreover, economic theory indicates that the equilibrium level of short-term real interest rates would likely remain low relative to estimates of its level before the financial crisis if trend growth of total factor productivity does not pick up and if demographic projections for slow growth in working-age populations are borne out. Finally, the staff discussed the implications of uncertainty about the level of the equilibrium real rate for using estimates of short-run r* as a guideline for appropriate monetary policy.”