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Summers Drops Out and the Bond Market Cheers



Traders often fixate on the appointment of a new Federal Reserve chairman. It was therefore no surprise that the news of Lawrence H. Summer’s nonselection was met with a pronounced financial market reaction. Especially notable was the 10 basis point drop in the 10-year Treasury yield.

A 10 basis point, one-day change in the bond yield is large by historical standards but not spectacularly so. Looking at the experience of 15 countries using data going back as far as the 1970s, Adam S. Posen and I found in a 2010 study that, while in most cases bond markets’ reactions to unexpected turnover in the chairman’s job were muted, there were a few instances in which the appointment generated strong responses. Seven of the 37 episodes we looked at were accompanied by reactions of at least 10 basis points.

Interestingly enough, the largest response we saw was to the appointment of Alan Greenspan to the chairmanship of the Fed on June 2, 1987. The bond market greeted the surprise announcement with dismay and the bond yield rose by 27 basis points. At the time, Greenspan was viewed as an unknown quantity on monetary policy and more dovish than his predecessor, Paul A. Volcker. The bond market also was a little skittish about Bernanke’s 2005 appointment, and the 10-year yield rose by 6 basis points.

Rightly or wrongly, Summers was perceived to be the most hawkish toward inflation of the possible candidates for the Fed chairmanship. His withdrawal of consideration for the job was seen in some quarters as clearing the path for a more dovish appointment, such as Janet Yellen, the current vice chair of the Fed. In light of this, the bond market’s response to Summers’ nonappointment is unusual. The appointments of Greenspan and Ben S. Bernanke, the current chair, as well as others in the Kuttner-Posen study, suggest that the bond market reacts adversely to dovish appointments, presumably because of the possibility of higher inflation. Precisely the opposite seems to have happened in this case.

It is always hazardous to read too much into a single observation, but the drop in the Treasury yield suggests that inflation is the least of the financial markets’ worries. There are three plausible reasons for this. The first is that with the unemployment rate still at 7.3 percent, there is no chance of the economy overheating. The second is that the market participants are confident that the Fed is well-equipped to undo its quantitative easing policies. And the third is that by articulating a 2 percent inflation objective, the Fed is committed to keeping inflation under control. Inflation scares are a thing of the past.

Kenneth N. Kuttner, a visiting fellow at the Peterson Institute, is a professor of economics at Williams College.

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