Risking Recession to Fend Off Inflation
The Federal Reserve has tightened credit with a series of six quarter point hikes that began in December 2015. Financial gurus expect four or five more hikes before the tightening cycle is finished. A question gaining traction among policy wonks is,"will the economy be pushed into recession before the tightening cycle is complete?” Asked another way, “When does monetary policy shift from facilitating the 'not too hot/ not too cold' Goldilocks economy to the iceberg that sank the Titanic?”
The Fed is balanced on razors edge
Recall that in our December 2017 post entitled Every Yield Curve Tells a Story, we noted that a flattening yield curve is a caution flag signaling to the Fed, markets and business leaders that the economy may soon lose momentum.
More importantly remember that an inverted curve raises the specter of recession.
Eight years of near zero policy rates has coaxed a long but modest recovery from the ashes of the Great Recession. It’s been over 9 years since the Business Cycle Dating Committee of the National Bureau of Economic Research called the Great Recession over. The average post World War 2 recovery has lasted less than 5 years.
The Fed is right to move the Funds Rate from the zero bound. They will need dry powder to fight the next recession.
But we must ask
How high is too high for policy rates? How flat is too flat for the yield curve? The debate has made its way to the Federal Reserve boardroom. New Chair Jay Powell worries that a flat or inverted curve will stall bank lending. St. Louis Fed president James Bullard is urging colleagues to debate the meaning of the flattening curve before inversion sets in. John Williams, the incoming president of the New York Fed noted an inverted curve “is a powerful signal of recession” that unnerves markets and corporate executives, particularly when the Fed is in a tightening cycle.
The Slippery Slope to Inversion
A walk across a frozen pond can take one from upright to upside down in the blink of an eye. The transition from flat to inverted curve comes fast and often leaves even the brightest economist sprawled and dazed. Former Fed Chairs Greenspan and Bernanke came to regret discounting the significance of the yield curve message.
Today the spread or yield differential
between 2’s and 10’s (the 2 and 10 Year Treasury) is about 50 basis points, the spread between 5’s and 30’s is only 33 basis points. Current spreads represent the flattest curve in more than a decade.
It took a brief 6 months for the curve to travel from similar spreads to inversion between 2005 and 2006.
An inverted curve has preceded every recession since 1955.
Money Market Messages
The money market yield curve remains comparatively steep. The yield spread between 1 month T-bills and the 2 Year Treasury note sits at 80 basis points. 6 month bills are 60 basis points below the 2 Year. These spreads hint at 2-3 additional policy hikes this year.
Yields on 10 to 30 year maturities must begin to move higher soon or recession worries are but two or three policy rate hikes away.
Why doesn’t the Fed cool its jets?
If policy rates are rising faster than long maturity yields, risking an inverted curve and recession why not slow the pace of hikes and let long rates catch up to policy?
Well there are two thoughts at play here.
First, the policy hawks fear inflation more than recession. The phenomenon of inflation is poorly understood and difficult to tame. Hawks see increasing inflation pressures behind every employee pay raise and uptick in commodity prices. Hawks believe rising borrowing costs subdue inflation.
The second deliberation gets back to dry powder to combat recession. In response to the last two recessions, the shallow 2001 speed bump and the devastating 2008 crater, the Fed dropped policy rates about 500 basis points. With the Fed Funds Rate currently at 1.75% the Fed is low on powder. Every quarter point hike puts a bit more distance between the Fed and the uncharted territory of negative US interest rates.
Is the Fed inviting the recession it’s preparing to fight?
Probably. A lot will depend upon how high short rates go and how fast they get there.
Will efforts to curb inflation slow economic growth?
Yes. Higher borrowing costs slow capital expenditures and consumer demand. Flat curves slow bank lending. Finance based economies struggle under the yoke of tight credit.
Will budget deficits push interest rates higher?
Recent increases in new US debt have been concentrated in short maturities. This contributes to a supply glut, higher yields and a flatter curve. The slope of the curve will be impacted by the maturity structure of the increase in new debt. More long debt issuance might help steepen the curve.
Keep your eyes on the yield curve friends.
Remember monetary policy impacts economies with a lag.
Inverted curves precede recessions by about 2 years.