This is why I told you in March to listen to Lael Brainard. She makes the intellectual case for inverting the yield curve

Back on March 1st, I told you to think of “Lael Brainard as the catalyst for Fed regime shift”. Here’s why:

Back in late 2015, she and Fed Governor Dan Tarullo expressed caution about raising interest rates. And as the Fed increased the Fed Funds rate, their cautious stance became Fed policy. Then in mid-2017, as Powell laid out the rules for quantitative tightening, Brainard favoured rate hikes. That signalled the Fed moving in a hawkish direction.

Powell has built consensus for a regime shift at the Fed. And Lael Brainard has been critical in making this happen.

Brainard’s latest comments on the Fed Funds rate

So, Brainard’s latest speech is critical to understanding where the Fed is heading. She’s titled it “What Do We Mean by Neutral and What Role Does It Play in Monetary Policy?“. Here are some important bits, the most critical ones in bold.

…many policymakers and economists find the concept of the neutral rate of interest to be a useful frame of reference. So, what does the neutral rate mean? Intuitively, I think of the nominal neutral interest rate as the level of the federal funds rate that keeps output growing around its potential rate in an environment of full employment and stable inflation.³

Focusing first on the “shorter-run” neutral rate, this does not stay fixed, but rather fluctuates along with important changes in economic conditions. For instance, legislation that increases the budget deficit through tax cuts and spending increases can be expected to generate tailwinds to domestic demand and thus to push up the shorter-run neutral interest rate. Heightened risk appetite among investors similarly can be expected to push up the shorter-run neutral rate. Conversely, many of the forces that contributed to the financial crisis–such as fear and uncertainty on the part of businesses and households–can be expected to lower the neutral rate of interest, as can declines in foreign demand for U.S. exports…

The longer-run equilibrium rate is a related concept. The underlying concept of the “longer run” generally refers to the output growing at its longer-run trend, after transitory forces reflecting headwinds or tailwinds have played out, in an environment of full employment and inflation running at the FOMC objective.⁴

…It is worth highlighting that the longer-run federal funds rate is the only neutral interest rate reported in the FOMC projections. But the shorter-run neutral rate, rather than the longer-run federal funds rate, is the relevant benchmark for assessing the near-term path of monetary policy in the presence of headwinds or tailwinds.

Here’s how to look at this; Brainard is saying that the Fed is looking through short-run data to focus on the medium term inflation and employment outlook in making decisions. But, at the same time, she says, the Fed can’t completely ignore the short-term because of short-term headwinds and tailwinds.

What about curve inversion then?

This is where the Fed’s policy path comes into play. Later in the speech, Brainard says:

…With government stimulus in the pipeline providing tailwinds to demand over the next two years, it appears reasonable to expect the shorter-run neutral rate to rise somewhat higher than the longer-run neutral rate. Further out, the policy path will depend on how the economy evolves.

These developments raise the prospect that, at some point, the Committee’s setting of the federal funds rate will exceed current estimates of the longer-run federal funds rate. Indeed, the median projection in the SEP has this property. This raises the possibility of a flattening or inversion of the yield curve in the event that term premiums do not rise from their currently very low levels.¹⁵

Implicitly, what Brainard has said is that the Fed can raise rates above its so-called long-term neutral rate to the point where the yield curve inverts. This is important because yield curve inversion has traditionally ‘predicted’ or presaged recession. So what does Brainard make of this possibility that the Fed would invert the curve?

Like many of you, I am attentive to the historical observation that inversions of the yield curve between the 3-month and 10-year Treasury rates have had a relatively reliable track record of preceding recessions in the United States.¹⁶ But unlike these historical episodes, today the current 10-year yield is very low at around 3 percent, which is well below the average of 6-1/4 percent during the decades before the crisis.

Translation: This time is different. Brainard is making the intellectual case for the Fed actively inverting the yield curve.

Conclusion

We should take this as clear policy guidance. The Fed is now prepared to invert the yield curve in the expectation that doing so does not automatically mean that recession will follow. It is going to do so cognizant of the risks of doing so because of the historical record of inversion preceding recession. Brainard says by hiking at a gradual pace, the Fed can manage this process well.

My view: This is a big experiment. And the risks to the US and global economy are considerable. I am willing to entertain the possibility that curve inversion won’t lead to recession. But I am definitely concerned. And I believe the credit cycle will turn in 2019. And it’s at that point we will see whether Brainard is right not to worry.