Alan Greenspan called it a conundrum: the refusal of long-term interest rates to ratchet higher as the Federal Reserve raised the overnight benchmark rate from 1 percent in June 2004 to 5.25 percent June 2006. Ben Bernanke, Greenspan's successor as Fed chief, identified the cause: a global savings glut.
Nomenclature and explanations aside, the yield curve inverted in mid-2006, and the outcome was entirely predictable: recession. Policy makers always find a way to rationalize the unnatural state where short rates exceed long rates rather than rely on the indicator's impeccable track record.
While the Fed has yet to begin its effort to normalize interest rates, already there is talk of a conundrum redux. Long-term yields have tumbled more than 100 basis points since the beginning of 2014 even as the U.S. economy strengthened. And once again, there is confusion over the implications.
Some of the misguided thinking is coming from the corridors of power - and policy - which makes it so troubling. New York Fed President Bill Dudley says the persistence of low long-term rates in the face of a rising benchmark rate would argue for "a more aggressive path of monetary policy normalization." The reason? Low bond yields create "a more accommodative set of financial market conditions," he said at a conference last month.
Perhaps Dudley should peruse the New York Fed's website, which features an entire section of economic research on the yield curve as a leading indicator, complete with a detailed set of FAQs. The bank even created a recession probability model based on the spread: the flatter or more inverted the curve, the greater the odds of recession. (The New York Fed model uses the three-month Treasury bill rate instead of the funds rate. Empirical research yields similar results using either rate.)
The current probability of recession is quite low given the steep yield curve. However, the spontaneous decline in long rates over the past year, unmotivated by any change in policy - actual or anticipated - has some economists wondering about a possible inversion in response to a modest amount of Fed tightening.
Dudley might want to review research that led the Conference Board's business cycle gurus to include the fed funds/10-year Treasury spread when they revamped the Index of Leading Economic Indicators in 1996. They added it for a reason: It leads. It leads both the business cycle and the nine other components of the LEI, including such stalwarts as initial unemployment claims, building permits and manufacturers' new orders. Over the last 60 years, the spread's average lead time at the peak has been 15 months, according to Ataman Ozyildirim, Director of Business Cycles and Growth Research at the Conference Board. That's more than enough time to find excuses as to why this time is different and why an inverted curve doesn't mean what it normally means.
What imbues the spread between two interest rates - one artificially pegged by the Fed, the other determined by the market - with such predictive powers? Think of the yield curve as an incentive for credit creation. The wider the spread, the greater the incentive for depository institutions to make loans or buy government bonds. Money and credit drive the business cycle.
For some reason, economists gloss over the spread in their eternal quest for the perfect financial conditions index. The Goldman Sachs FCI was one such attempt. When I first wrote about the GSFCI in 2000, it was comprised of four variables: a real short-term rate, a real long-term rate, the dollar exchange rate and a stock market variable. I pointed out that a rise in the long rate could be a reflection of increased demand for credit or reduced supply, with very different implications for the economy. Yet in both cases, the rise in long rates would represent a tightening of financial conditions, according to the GSFCI.
Dudley, who at the time was chief economist at Goldman, acknowledged as much, claiming that the index needed to be "interpreted in the context of the environment." If judgment is required, what then is the value of an index?
For the record, it is the level of the spread, not the change in it,that has the greatest predictive power. Why or how the curve inverts is irrelevant. It's the "what" that matters.
Low long-term rates aren't unique to the U.S. right now. As former Fed chairman Ben Bernanke explained in his first blog post for the Brookings Institution this week, the state of the economy, not the central bank, "determines the real rate of return" on investment, represented by an inflation-adjusted long-term rate.
If the constraints on the economy are such that the equilibrium long-term rate, or natural rate, is depressed, it will require only modest rate increases by the Fed when it comes time to apply the brakes. That's what the market is telegraphing, and it's the antithesis of what Dudley is suggesting.
Caroline Baum is a contributor to e21. You can follow her on Twitter here.
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