Just following up on my last post about the expectations theory of interest rates, I wanted to explain why yield curve inversion signals recession – and why it hasn’t this go round in the US.
You have probably heard or read somewhere that an inverted yield curve was a great leading indicator of recessions. Before the recession and financial panic in 2008, many supporters of the global savings glut theory called this indicator of recession into question. Instead, they explained the Greenspan conundrum of long-term interest rates not responding to the Fed’s policy rate hikes as a sign of excess Asian savings getting recycled into US treasury bonds.
Federal Reserve Chairman Ben Bernanke pushed this view very aggressively.
I quote:
I would not interpret the currently very flat yield curve as indicating a significant economic slowdown to come…
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.
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.
–Ben Bernanke: Reflections on the Yield Curve and Monetary Policy (Before the Economic Club of New York, New York, New York, March 20, 2006)
I call this the “Blame Asia meme”. When a significant economic slowdown did indeed come, this "global saving glut" theory should have been dismissed as bogus since events proved it wrong.
Indeed, an alternative perspective, the expectations theory, holds that longer-term interest rates are determined by investor expectations of future short-term rates. The central bank, as the monopolist for overnight money, alters the term structure of interest rates by adjusting expectations of future interest rate policy.
For example, if the ECB is dovish about rates now that a European double dip seems imminent, then the yield curve will flatten as bond market players anticipate future rate cuts. This is why I wrote in August that the Fed has already begun its third easing campaign when it ‘guaranteed’ interest rates out to two years.
In places like India and Brazil, where inflation has been a problem and the economy was overheating earlier in the year, yield curve inversion signalled expectations of so much policy tightening that the economy would be negatively impacted, forcing the central bank to ease. That is what an inverted yield curve is all about: it is a sign that markets expect interest rates to be lower in the future – and this is usually because economic weakness causes the central bank to cut the policy rate.
In the US, the policy rate is effectively at the zero lower bound. If the Fed is telling us that rates will be zero for two years, how are they going to get the yield curve to invert due to expected future cuts? They can’t get inversion unless they force rates below the so-called zero lower bound. Right now, markets, therefore, expect the Fed to keep rates at near zero percent for a long time to come; and this spells yield curve flattening and not inversion.
That said, I have speculated that the Fed may resort to more draconian easing measures the longer this economic malaise continues. Here is one way the Fed can counteract the zero lower bound and force inversion:
To set a negative fed fund rate, the Fed just has to do overnight repos on securities at a premium. If one applies this to zero-coupon securities like T-bills, the present value of a T-bill is:
P = F/(1 + d)t
P is the present value, F is the face value, d is the discount factor, and t is time to maturity (let’s set t = 1 to simplify). Usually, d is positive meaning that the Fed buys T-bills at $90 and bankers agree to buy back the next day at $95 (d = 5%). Currently, for practical purposes one can assume that d = 0%, i.e. if bankers want reserves from the Fed, they sell T-bills at $90 and promise to buy them back at $90 the next day. To set d negative, the only thing the Fed has to do is to buy at $95 and resell at $90; stated differently, the Fed just has to agree to accept T-bills as collateral at a value of $95 and bankers have to agree to buy them back at $90 the next day. In this case the federal funds rate target will be negative 5%: 90/95 – 1. If the Fed performs enough of these kinds of operations, the federal funds rate will reach the -5% target.
So there is no operational constraint on setting negative nominal interest rates.
–Is there a zero bound? The “mysterious” world of negative nominal interest rates, Eric Tymoigne
Whether the Fed goes negative or not, it should now be clear that the “global savings glut” and the “Blame Asia” meme are voodoo economics. The Fed controls US interest rates. And when the next downturn becomes apparent to everyone, I believe the Fed, understanding their control, will counteract the deflationary impact of this credit crisis by whatever means necessary.