Expansions that didn’t die in their beds but were murdered by the Federal Reserve
“None of the post-war expansions died of old age. They were all murdered by the Fed.”
-Rudi Dornbusch, famous MIT economist
I’ve been following the Fed’s forward guidance recently and, frankly, I find it confused. On the one hand, it was a clear mistake to have raised rates in December. We see this now in retrospect due to the tightening of financial conditions that policy divergence , a strong dollar and the collapse of oil prices had wrought in January and February. The Fed recognized the shift and backpedaled on its ‘promise’ of 300 basis points of rate hikes through 2018. But, now that financial conditions have eased, the Fed is back to talking up rate hikes yet again – this, despite a flattening yield curve.
Now, I will grant the Fed some suspension of disbelief here since we are seeing a deleterious impact to private sector income due to the reduction of interest income. I could even envision a scenario in which rate hikes added stimulus by adding interest income without tightening financial conditions too much. Arguably this would be the situation if the Fed raised rates and the yield curve steepened. But the yield curve doesn’t lie. A flattening yield curve is a sign of tightening. And a flat yield curve is a strong indication of significantly tightened financial conditions, whether or not these conditions are being reflected in equity markets or not. My sense is that the Fed is failing to take this signal seriously.
Let’s go the video tape, shall we?
I came across a 2011 analysis by Ambassador Financial (pdf here) which showed the following:
- “In 1992 the slope of the curve was 250 basis points. As the Fed began to raise short-term rates in 1993 and 1994, the curve flattened and in 1995, the slope was 10 basis points. “
- “In 1998, the curve was already very flat sitting at 55 basis points. When the Fed hiked rates in 1999–2000, the curve became inverted at negative 50 basis points. “
- ” In 2003, the curve was steep again with the difference between the two-year and 10-year at 260 basis points. When the Fed began to raise rates in 2004–2006, the curve became inverted by 15 basis points in 2007.”
Ambassador’s conclusion was that rate increases do not steepen the yield curve – they flatten it, and that over the last three tightening cycles the average flattening was 200 basis points.
I think this is right. And right now, the yield curve is flattening. As this Wall Street Journal chart demonstrates, the flattening has occurred ever since the Fed’s forward guidance switched from quantitative easing to tapering and then to rate hikes.
With the 10-year at 1.85% and the 2-year at 0.92%, that leaves us 93 basis points from inversion. So when John Williams talks about 5 to 7 rate hikes through 2017, he assumes long rates will go up by at least 75 basis points – or you have the Fed creating inversion – murdering the expansion, if you will.
You would think the Fed would see this. But evidence is that it does not. For example, as the US economy was peaking during the housing bubble, Ben Bernanke gave a long explanation for why a flattening yield curve didn’t necessarily mean anything. Here’s what he said in March of 2006 – and I will quote at length here, bolding the parts to pay attention to:
Long-Term Yields and Monetary Policy
What does the historically unusual behavior of long-term yields imply for the conduct of monetary policy? The answer, it turns out, depends critically on the source of that behavior. To the extent that the decline in forward rates can be traced to a decline in the term premium, perhaps for one or more of the reasons I have just suggested, the effect is financially stimulative and argues for greater monetary policy restraint, all else being equal. Specifically, if spending depends on long-term interest rates, special factors that lower the spread between short-term and long-term rates will stimulate aggregate demand. Thus, when the term premium declines, a higher short-term rate is required to obtain the long-term rate and the overall mix of financial conditions consistent with maximum sustainable employment and stable prices.
However, if the behavior of long-term yields reflects current or prospective economic conditions, the implications for policy may be quite different–indeed, quite the opposite. The simplest case in point is when low or falling long-term yields reflect investor expectations of future economic weakness. Suppose, for example, that investors expect economic activity to slow at some point in the future. If investors expect that weakness to require policy easing in the medium term, they will mark down their projected path of future spot interest rates, lowering far-forward rates and causing the yield curve to flatten or even to invert. Indeed, historically, the slope of the yield curve has tended to decline significantly in advance of recessions.
What is the relevance of this scenario for today? Although macroeconomic forecasting is fraught with hazards, I would not interpret the currently very flat yield curve as indicating a significant economic slowdown to come, for several reasons. First, in previous episodes when an inverted yield curve was followed by recession, the level of interest rates was quite high, consistent with considerable financial restraint. This time, both short- and long-term interest rates–in nominal and real terms–are relatively low by historical standards.5Second, as I have already discussed, to the extent that the flattening or inversion of the yield curve is the result of a smaller term premium, the implications for future economic activity are positive rather than negative.6 Finally, the yield curve is only one of the financial indicators that researchers have found useful in predicting swings in economic activity. Other indicators that have had empirical success in the past, including corporate risk spreads, would seem to be consistent with continuing solid economic growth. In that regard, the fact that actual and implied volatilities of most financial prices remain subdued suggests that market participants do not harbor significant reservations about the economic outlook.
An alternative perspective holds that the recent behavior of interest rates does not presage an economic slowdown but suggests instead that the level of real interest rates consistent with full employment in the long run–the natural interest rate, if you will–has declined. For example, some observers have pointed to factors that may create a longer-term drag on the growth in household spending, including high energy costs, the likelihood of slower growth in house prices, and a possible reversal of recent declines in saving rates. If these drags on the growth of spending do materialize, then a lower real interest rate will be needed to sustain aggregate demand and keep the economy near full employment. To be consistent with a lower long-term real rate, the short-term policy rate might have to be lower than it would otherwise be as well.
Given the global nature of the decline in yields, an explanation less centered on the United States might be required. About a year ago, I offered the thesis that a “global saving glut”–an excess, at historically normal real interest rates, of desired global saving over desired global investment–was contributing to the decline in interest rates.7 In brief, I argued that this shift reflects the confluence of several forces. On the saving side, the factors include rapid growth in high-saving countries on the Pacific Rim, export-focused economic development strategies that directly or indirectly hold back the growth of domestic demand, and the surge in revenues enjoyed by oil producers. On the investment side, notable factors restraining the global demand for capital include the legacy of the Asian financial crisis of the late 1990s, which led to continuing sluggishness in investment in some of those economies, and the slower growth of the workforce in many industrial countries. So long as these factors persist, global equilibrium interest rates (and, consequently, the neutral policy rate) will be lower than they otherwise would be.
I don’t think this explanation makes sense in retrospect. First, if spending depends on long-term interest rates – as in interest income – then long-term rates need to be higher relative to short rates not lower; the yield curve would need to steepen and not flatten as Bernanke says. Second, I question the concept that lower term premia are a positive economic signal. To the degree term premia are lower, it could signal that investors are starved for yield and are willing to move out the curve in order to get yield. That’s a negative, not a positive. And third, the global savings glut hypothesis is based on a misunderstanding of how money is created – as if credit flows from existing loanable funds rather than the opposite in which deposits are created by loans. None of what Bernanke writes convinces me.
I am left believing Bernanke came up with an intellectual framework to justify disregarding the negative signal that a flattening yield curve was sending. And as a result, I believe it is plausible that the Fed is doing the same thing again today.
Like Bernanke, I am willing to entertain the idea that the conventional wisdom on business cycles is wrong. In my case, it’s the conventional wisdom that interest rate hikes are always brakes on the economy rather than also potentially being stimulus that pulls forward borrowing and increases interest income. In Bernanke’s case, it was the conventional wisdom that a flattening yield curve was a harbinger of a poor economy because of interest rate expectations rather than a sign of economic strength due to risk-on behavior as reflected by lower term premia. But this whole concept that a flat yield curve isn’t a bad thing needs to be treated with scepticism. If the present Fed is thinking today what Bernanke was thinking in 2006, then they could push up rates unexpectedly, causing the yield curve to flatten even more. And if they do, I foresee economic weakness as a strong dollar, lower oil prices and higher discount rates on risk assets take their toll. And if the Fed raises rates and inverts, the yield curve, it will have no one else to blame but itself if this leads to recession.