The yield curve has inverted eight times in the last half century, and in six of those
episodes, the U.S. ended up in recession. Some analysts are concerned that we may see a ninth
inversion before the end of this year.
One of the economic indicators that many of us follow closely is the difference in yields
between assets of different maturities. Below is a graph of the difference between the yield on
10-year U.S. Treasury bonds and the average federal funds rate (an overnight one-day interest rate)
going back to 1954. Usually the longer-term maturity pays a higher yield; historically this spread
has averaged around 0.9% (a little below 100 basis points). Having gone through an unusual
three-year episode in which the spread was well above this average, we’re now right about back to
the historical average.
But most analysts are predicting that the Fed will raise the fed funds rate up to 3.25 at its
next meeting, and fed
funds options are currently reflecting a belief by the market that there’s as much as a 15%
chance that the Fed will leap up to a 4.0% target for fed funds by October, according to David
Altig’s latest calculations href="http://macroblog.typepad.com/macroblog/fed_funds_futures/index.html"> over at macroblog.
If 10-year yields hold on to a value below 4.0%, that would leave us in the historically unusual
situation of an inverted yield curve, in which the fed funds rate is actually above the 10-year
rate. This possibility has raised concerns by many analysts, such as Bloomberg’s href="http://quote.bloomberg.com/apps/news?pid=10000039&refer=columnist_baum&sid=aKYcCy8UTmdE#">
So what’s the worry in an inverted yield curve? The above graph indicates with shaded areas
the times in which the U.S. economy went into a recession as determined by the href="http://www.nber.org/cycles/main.html"> National Bureau of Economic Research. The yield
curve only inverted 8 times in the last half century, and on six of those occasions, the U.S. went
into a recession. There have been many dozens of academic investigations of the statistical
correlation between the yield spread and economic activity, which generally confirm what you’d
expect from the above graph: the lower long-term yields are relative to short-term yields, the more
pessimistic your forecast of GDP growth becomes. href="http://ksghome.harvard.edu/~JStock/pdf/Stock_Watson_JEL_2003.pdf"> James Stock and Mark
Watson have a nice survey of this literature.
There are several theories for what may explain this correlation. The most straightforward has
to do with monetary policy. The Fed controls the fed funds rate directly through its control over
bank reserves and the nation’s liquidity, but influences the long rate more indirectly through a
combination of the intermediate-term liquidity prospects and longer-term inflation. When the Fed
is tightening, as it has been for the last year, short rates go up relative to the long rates. And
if the Fed tightens too much, the economy slips into recession.
So why would the Fed keep doing this to us? Conducting monetary policy is complicated by the
fact that there is a significant time delay between the date at which the Fed takes an action and
the date at which the economy responds. Doing the right thing therefore calls not just for an
assessment of where the economy is at the moment but also a prediction about where it’s going to be
6 months or a year down the road.
It’s awfully easy to fall behind in that game. A common historical pattern is that the Fed
gets concerned when the economy starts to stumble, so begins to lower interest rates aggressively.
The economy doesn’t seem to be responding, so the Fed gets even more aggressive, and continues to
pump money into the economy because they don’t recognize that a recovery is under way. Later on
when the economy starts to boom, the inflationary consequences of that expansion catch up with us,
so the Fed starts to ratchet rates up in an effort to bring inflation back under control. The
policy delays between monetary expansion and inflation are even longer than those between a Fed
contraction and recession. So the Fed sees that inflation continues to climb despite its efforts,
and figures that it needs to tighten still further. Once the recession begins, the Fed belatedly
figures out that it went too far, and the whole cycle is repeated again on the way back down.
It sure seemed to me that the first part of that common historical pattern was repeated this
go-round, with the Fed overstimulating the economy in bringing interest rates all the way down to
1% in 2003. Now it appears that they’re worried about the inflationary consequences of that
overexpansion. If we’d held the rate at 2% through 2002, there might never have been a need to
raise it above that now.
As I noted
here, a rapid rise in oil prices is another indicator that has also been historically
associated with economic recessions. If we do see the 100-basis point increase in the short rate
over the summer that some market participants seem to think is a possibility, a prudent person
should be quite concerned.
I hope that the market guess of a 4% fed funds rate is wrong, and think it probably will be.
The Fed couldn’t be that stupid, could it?