Uneasy Money

Last week the Fed again raised its benchmark Federal Funds rate target, now at 2%, up from the 0.25% rate that had been maintained steadily from late 2008 until late 2015, when the Fed, after a few false starts, finally worked up the courage — or caved to the pressure of the banks and the financial community — to start raising rates. The Fed also signaled its intention last week to continue raising rates – presumably at 0.25% increments – at least twice more this calendar year.

Some commentators have worried that rising short-term interest rates are outpacing increases at the longer end, so that the normally positively-sloped yield curve is flattening. They point out that historically flat or inverted yield curves have often presaged an economic downturn or recession within a year.

What accounts for the normally positive slope of the yield curve? It’s usually attributed to the increased risk associated with a lengthening of the duration of a financial instrument, even if default risk is zero. The longer the duration of a financial instrument, the more sensitive the (resale) value of the instrument to changes in the rate of interest. Because risk falls as the duration of the of the instrument is shortened, risk-averse asset-holders are willing to accept a lower return on short-dated claims than on riskier long-dated claims.

If the Fed continues on its current course, it’s likely that the yield curve will flatten or become inverted – sloping downward instead of upward – a phenomenon that has frequently presaged recessions within about a year. So the question I want to think through in this post is whether there is anything inherently recessionary about a flat or inverted yield curve, or is the correlation between recessions and inverted yield curves merely coincidental?

The beginning of wisdom in this discussion is the advice of Scott Sumner: never reason from a price change. A change in the slope of the yield curve reflects a change in price relationships. Any given change in price relationships can reflect a variety of possible causes, and the ultimate effects, e.g., an inverted yield curve, of those various underlying causes, need not be the same. So, we can’t take it for granted that all yield-curve inversions are created equal; just because yield-curve inversions have sometimes, or usually, or always, preceded recessions doesn’t mean that recessions must necessarily follow once the yield curve becomes inverted.

Let’s try to sort out some of the possible causes of an inverted yield curve, and see whether those causes are likely to result in a recession if the yield curve remains flat or inverted for a substantial period of time. But it’s also important to realize that the shape of the yield curve reflects a myriad of possible causes in a complex economic system. The yield curve summarizes expectations about the future that are deeply intertwined in the intertemporal structure of an economic system. Interest rates aren’t simply prices determined in specific markets for debt instruments of various durations; interest rates reflect the opportunities to exchange current goods for future goods or to transform current output into future output. Interest rates are actually distillations of relationships between current prices and expected future prices that govern the prices and implied yields at which debt instruments are bought and sold. If the interest rates on debt instruments are out of line with the intricate web of intertemporal price relationships that exist in any complex economy, those discrepancies imply profitable opportunities for exchange and production that tend to eliminate those discrepancies. Interest rates are not set in a vacuum, they are a reflection of innumerable asset valuations and investment opportunities. So there are potentially innumerable possible causes that could lead to the flattening or inversion of the yield curve.

For purposes of this discussion, however, I will focus on just two factors that, in an ultra-simplified partial-equilibrium setting, seem most likely to cause a normally upward-sloping yield curve to become relatively flat or even inverted. These two factors affecting the slope of the yield curve are the demand for liquidity and the supply of liquidity.

An increase in the demand for liquidity manifests itself in reduced current spending to conserve liquidity and by an increase in the demands of the public on the banking system for credit. But even as reduced spending improves the liquidity position of those trying to conserve liquidity, it correspondingly worsens the liquidity position of those whose revenues are reduced, the reduced spending of some necessarily reducing the revenues of others. So, ultimately, an increase in the demand for liquidity can be met only by (a) the banking system, which is uniquely positioned to create liquidity by accepting the illiquid IOUs of the private sector in exchange for the highly liquid IOUs (cash or deposits) that the banking system can create, or (b) by the discretionary action of a monetary authority that can issue additional units of fiat currency.

Let’s consider first what would happen in case of an increased demand for liquidity by the public. Such an increased demand could have two possible causes. (There might be others, of course, but these two seem fairly commonplace.)

First, the price expectations on which one or more significant sectors of the economy have made investments have turned out to overly optimistic (or alternatively made investments on overly optimistic expectations of low input prices). Given the commitments made on the basis of optimistic expectations, it then turns out that realized sales or revenues fall short of what was required by those firms to service their debt obligations. Thus, to service their debt obligations, firms may seek short-term loans to cover the shortfall in earnings relative to expectations. Potential lenders, including the banking system, who may already be holding the debt of such firms, must then decide whether to continue extending credit to these firms in hopes that prices will rebound back to what they had been expected to be (or that borrowers will be able to cut costs sufficiently to survive if prices don’t recover), or to cut their losses by ceasing to lend further.

The short-run demand for credit will tend to raise short-term rates relative to long-term rates, causing the yield curve to flatten. And the more serious the short-term need for liquidity, the flatter or more inverted the yield curve becomes. In such a period of financial stress, the potential for significant failures of firms that can’t service their financial obligations is an indication that an economic downturn or a recession is likely, so that the extent to which the yield curve flattens or becomes inverted is a measure of the likelihood that a downturn is in the offing.

Aside from sectoral problems affecting particular industries or groups of industries, the demand for liquidity might increase owing to a generalized increase in uncertainty that causes entrepreneurs to hold back from making investments (dampens animal spirits). This is often a response during and immediately following a recession, when the current state of economic activity and uncertainty about its future state discourages entrepreneurs from making investments whose profitability depends on the magnitude and scope of the future recovery. In that case, an increasing demand for liquidity causes firms to hoard their profits as cash rather than undertake new investments, because expected demand is not sufficient to justify commitments that would be remunerative only if future demand exceeds some threshold. Such a flattening of the yield curve can be mitigated if the monetary authority makes liquidity cheaply available by cutting short-term rates to very low levels or even to zero, as the Fed did when it adopted its quantitative easing policies after the 2008-09 downturn, thereby supporting a recovery, a modest one to be sure, but still a stronger recovery than occurred in Europe after the European Central Bank prematurely raised interest short-term rates.

Such an episode occurred in 2002-03, after the 9-11 attack on the US. The American economy had entered a recession in early 2001, partly as a result of the bursting of the dotcom bubble of the late 1990s. The recession was short and mild, and the large tax cut enacted by Congress at the behest of the Bush administration in June 2001 was expected to provide significant economic stimulus to promote recovery. However, it soon became clear that, besides the limited US attack on Afghanistan to unseat the Taliban regime and to kill or capture the Al Qaeda leadership in Afghanistan, the Bush Administration was planning for a much more ambitious military operation to effect regime change in Iraq and perhaps even in other neighboring countries in hopes of radically transforming the political landscape of the Middle East. The grandiose ambitions of the Bush administration and the likelihood that a major war of unknown scope and duration with unpredictable consequences might well begin sometime in early 2003 created a general feeling of apprehension and uncertainty that discouraged businesses from making significant new commitments until the war plans of the Administration were clarified and executed and their consequences assessed.

Gauging the unusual increase in the demand for liquidity in 2002 and 2003, the Fed reduced short-term rates to accommodate increasing demands for liquidity, even as the economy entered into a weak expansion and recovery. Given the unusual increase in the demand for liquidity, the accommodative stance of the Fed and the reduction in the Fed Funds target to an unusually low level of 1% had no inflationary effect, but merely cushioned the economy against a relapse into recession. The weakness of the recovery is reflected in the modest rate of increase in nominal spending, averaging about 3.9%, and not exceeding 5.1% in any of the seven quarters from 2001-IV when the recession ended until 2003-II when the Saddam Hussein regime was toppled.

Quarter              % change in NGDP

2001-IV               2.34%

2002-I                 5.07%

2002-II                3.76%

2002-III               3.80%

2002-IV               2.44%

2003-I                 4.63%

2003-II                5.10%

2003-III               9.26%

2003-IV               6.76%

2004-I                 5.94%

2004-II                6.60%

2004-III               6.26%

2004-IV               6.44%

2005-I                 8.25%

2005-II                5.10%

2005-III               7.33%

2005-IV               5.44%

2006-I                 8.23%

2006-II                4.50%

2006-III               3.19%

2006-IV               4.62%

2007-I                 4.83%

2007-II                5.42%

2007-III               4.15%

2007-IV               3.21%

The apparent success of the American invasion in the second quarter of 2003 was matched by a quickening expansion from 2003-III through 2006-I, nominal GDP increasing at a 6.8% annual rate over those 11 quarters. As the economy recovered, and spending began increasing rapidly, the Fed gradually raised its Fed Funds target by 25 basis points about every six weeks starting at the end of June 2004, so that in early 2006, the Fed Funds target rate reached 4.25%, peaking at 5.25% in July 2006, where it remained till September 2007. By February 2006, the yield on 3-month Treasury bills reached the yield on 10-year Treasuries, so that the yield curve had become essentially flat, remaining so until October 2008, soon after the start of the financial crisis. Indeed, for most of 2006 and 2007, the Fed Funds target was above the yield on three-month Treasury bills, implying a slight inversion at the short-end of the yield curve, suggesting that the Fed was exacting a slight liquidity surcharge on overnight reserves and that there was a market expectation that the Fed Funds target would be reduced from its 5.25% peak.

The Fed was probably tardy in increasing its Fed Funds target till June 2004, nominal spending having increased in 2003-III at an annual rate above 9%, and increasing in the next three quarters at an average annual rate of about 6.5%. In 2005 while the Fed was in auto-pilot mode, automatically raising its Fed Funds target 25 basis points every six weeks, nominal spending continued to increase at a roughly 6% annual rate, increases becoming slightly more erratic, fluctuating between 5.1% and 8.3%. But by the second quarter of 2006 when the Fed Funds target rose to 5%, the rate of increase in spending slowed to an average of just over 4% and just under 5% in the first three quarters of 2007.

While the rate of increase in spending slowed to less than 5% in the second quarter of 2006, as the yield curve flattened, and the Fed Funds target peaked at 5.25%, housing prices also peaked, and the concerns about financial stability started to be voiced. The chart below shows the yields on 10-year constant maturity Treasuries and the yield on 3-month Treasury bills, the two key market rates at opposite ends of the yield curve.

The yields on the two instruments became nearly equal in early 2006, and, with slight variations, remained so till the onset of the financial crisis in September 2008. In retrospect, at least, the continued increases in the Fed Funds rate target seem too have been extremely ill-advised, perhaps triggering the downturn that started at the end of 2007, and leading nine months later to the financial crisis of 2008.

The Fed having put itself on autopilot, the yield curve became flat or even slightly inverted in early 2006, implying that a substantial liquidity premium had to be absorbed in order to keep cash on hand to meet debt obligations. By the second quarter of 2006, insufficient liquidity caused the growth in total spending to slow, just when housing prices were peaking, a development that intensified the stresses on the financial system, further increasing the demand for liquidity. Despite the high liquidity premium and flat yield curve, total spending continued to increase modestly through 2006 and most of 2007. But after stock prices dropped in August 2007 and home prices continued to slide, growth in total spending slowed further at the end of 2007, and the downturn began.

Responding to signs of economic weakness and falling long-term rates, the Fed did lower its Fed Funds target late in 2007, cutting the Fed Funds target several more times in early 2008. In May 2008, the Fed reduced the target to 2%, but the yield curve remained flat, because the Fed, consistently underestimating the severity of the downturn, kept signaling its concern with inflation, thereby suggesting that an increase in the target might be in the offing. So, even as it reduced its Fed Funds target, the Fed kept the yield curve nearly flat until, and even after, the start of the financial crisis in September 2008, thereby maintaining an excessive liquidity premium while the demand for liquidity was intensifying as total spending contracted rapidly in the third quarter of 2008.

To summarize this discussion of the liquidity premium and the yield curve during the 2001-08 period, the Fed appropriately steepened the yield curve right after the 2001 recession and the 9/11 attacks, but was slow to normalize the slope of the yield curve after the US invasion of Iraq in the second quarter of 2003. When it did begin to normalize the yield curve in a series of automatic 25 basis point increases in its Fed Fund target rate, the Fed was again slow to reassess the effects of the policy as yield curve flattened in 2006. Thus by 2006, the Fed had effectively implemented a tight monetary policy in the face of rising demands for liquidity just as the bursting of the housing bubble in mid-2006 began to subject the financial system to steadily increasing stress. The implications of a flat or slightly inverted yield curve were ignored or dismissed by the Fed for at least two years until after the financial panic and crisis in September 2008.

At the beginning of the 2001-08 period, the Fed seemed to be aware that an unusual demand for liquidity justified a policy response to increase the supply of liquidity by reducing the Fed Funds target and steepening the yield curve. But, at the end of the period, the Fed was unwilling to respond to increasing demands for liquidity and instead allowed a flat yield curve to remain in place even when the increasing demand for liquidity was causing a slowdown in aggregate spending growth. One possible reason for the asymmetric response of the Fed to increasing liquidity demands in 2002 and 2006 is that the Fed was sensitive to criticism that, by holding short-term rates too low for too long, it had promoted and prolonged the housing bubble. Even if the criticism contained some element of truth, the Fed’s refusal to respond to increasing demands for liquidity in 2006 was tragically misguided.

The current Fed’s tentative plan to keep increasing the Fed Funds target seems less unreflective as the nearly mindless schedule followed by the Fed from mid-2004 to mid-2006. However, the Fed is playing a weaker hand now than it did in 2004. Nominal GDP has been increasing at a very lackluster annual rate of about 4-4.5% for the past two years. Certainly, further increases in the Fed Funds target would not be warranted if the rate of growth in nominal GDP is any less than 4% or if the yield curve should flatten for some other reason like a decline in interest rates at the longer end of the yield curve. Caution, possible inversion ahead.