As Nick Timiraos ably describes, there’s a debate afoot about how seriously to take the flattening and possible future inversion of the yield curve. I got into this a bit last week, pointing out that the signal from the yield curve is a lot more ambiguous than usual (my conclusion was that we should worry a lot more about how we’re going to offset the next recession versus when it’s coming, which is not reliably knowable).
One reason for this ambiguity is the very low term premium on long-term bond yields (see figure). Longer-term interest rates, like the yield on the 10-year Treasury, can be broken up into the expectation of the average of future short-term rates and the term premium, or the extra yield investors require to lock up their money for the term of the loan. Since it’s thought to be the first part — expected rates — that correlates with future downturns, it makes sense to net out the term premium from the model. As the next figure shows, that significantly lowers the curve recession probability (see these Fed papers for details). As economist David Mericle recently put it, low term premia imply that “an inversion…no longer signals that current interest rates are nearly as far above expected average future short rates as in the past.”
But for this quick post, I want to get a bit more into what an inversion might mean for Fed policy. Would recessionary signals from an inversion lead them to pause in their rate hike campaign?
I doubt it, and agree with Jan Hatzius: “…yield curve inversion does not cause recession, but is merely indicative of the types of conditions (i.e. overheating) that are often followed by recession. This sounds like a technical distinction but implies, crucially, that the Fed cannot lower the risk of recession simply by refusing to deliver hikes that would invert the curve. This would worsen the overheating and could ultimately lead to an even bigger inversion and an even higher risk of recession.”
We can and should have good debates about the extent of overheating in the current economy, about which I’m pretty dovish. Yes, inflation’s up a bit, but a) it should be at this point in the expansion, b) core PCE just hit 2%–the Fed’s target—after being below target for years, c) most importantly, inflation expectations remain as well-anchored as ever.
So, based on extraneous factors flattening the curve and the low likelihood that an inversion may not much alter the Fed’s normalization plans, I’d pretty heavily discount the yield curve. Of course, that doesn’t mean a recession isn’t out there somewhere—it is. We still don’t know where, but unless it’s unusually mild, we can be pretty confident that neither monetary nor especially fiscal policy will be poised to do enough to offset it.