Yield-Curve Inversion and the Agony of Central Banking

Suddenly, we have been beset with a minor panic attack about our increasingly inverted yield curve. Since fear of yield-curve inversion became a thing a little over a year ago, a lot of people have taken notice of the fact that yield-curve inversion has often presaged recessions. In June 2018, when the yield curve was on the verge of flatlining, I tried to explain the phenomenon, and I think that I provided a pretty good — though perhaps a tad verbose — explanation, providing the basic theory behind the typical upward slope of the yield curve as well as explaining what seems the most likely, though not the only, reason for inversion, one that explains why inversion so often is a harbinger of recession.

But in a Tweet yesterday responding to Sri Thiruvadanthai I think I framed the issue succinctly within the 280 character Twitter allotment. Here are the two tweets.



And here’s a longer version getting at the same point from my 2018 post:

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.

The question that I want to address now is why has the yield curve, after having been only slightly inverted or flat for the past year, suddenly — since about the beginning of August — become sharply inverted.

Last summer, when concerns about inversion was just beginning to be discussed, the Fed, which had been signaling a desire to raise short-term rates to “normal” levels, changed signals, indicating that it would not automatically continue raising rates as it had between 2003 and 2006, but would evaluate each rate increase in light of recent data bearing on the state of the economy. So after a further half-a-percent increase in the Fed’s target rate between June and the end of 2018, the Fed held off on further increases, and in July actually cut its rate by a quarter of a percent and even signaled a likely further quarter of a percent decrease in September.

Now to be sure the Fed might have been well-advised not to have raised its target rate as much as it did, and to have cut its rate more steeply than it did in July. Nevertheless, it would be hard to identify any particular monetary cause for the recent steep further inversion of the yield curve. So, the most likely reason for the sudden inversion is nervousness about the possibility of a trade war, which most people do not think is either good or easy to win.

After yesterday’s announcement by the administration that previously announced tariff increases on Chinese goods scheduled to take effect in September would be postponed until after the Christmas buying season, the stock market took some comfort in an apparent easing of tensions between the US and China over trade policy. But this interpretation was shot down by none other than Commerce Secretary Wilbur Ross who, before the start of trading, told CNBC that the administration’s postponement of the tariffs on China was done solely in the interest of American shoppers and not to ease tensions with China. The remark — so unnecessary and so counterproductive — immediately aroused suspicions that Ross had an ulterior motive, like, say, a short position in the S&P 500 index, in sharing it on national television.

So what’s going on? Monetary policy has probably been marginally too tight for that past year, but only marginally. Unlike other inverted yield curve episodes that Fed has not been attempting to reduce the rate of inflation and has even been giving lip service to the goal of raising the rate of inflation, so if the Fed’s target rate was raised too high, it was based on an expectation that the economy was in the midst of an expansion; it was not an attempt to reduce growth. But the economy has weakened, and all signs suggest that the weakness stems from an uncertain economic environment particularly owing to the risk that new tariffs will be imposed or existing ones raised to even higher levels, triggering retaliatory measures by China and other affected countries.

In my 2018 post I mentioned a similar, but different, kind of uncertainty that held back recovery from the 2001-02 recession.

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.

The Fed responded to the uncertain environment of 2002 with a series of interest rate reductions that prevented a lapse into recession.

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.

Recently, the uncertainty caused by the imposition of tariffs and the threat of a destructive trade war seems to have discouraged firms to go forward with plans to invest and to expand output as decision-makers prefer to wait and see how events play out before making long-term commitments that would put assets and investments at serious risk if a trade war undermines the conditions necessary for those investment to be profitable. In the interim, decision-makers seeking short-term safety and the flexibility to deploy their assets and resources profitably once future prospects become less uncertain leads them to take highly liquid positions that don’t preclude taking future profitable actions once profitable opportunities present themselves.

However, when everyone resists making commitments, economic activity doesn’t keep going as before, it gradually slows down. And so a state of heightened uncertainty eventually leads to a stagnation or recession or something worse. To prevent or mitigate that outcome, a reduction in interest rates by the central bank can prevent or at least postpone the onset of a recession, as the Fed succeeded in doing in 2002-03 by reducing its interest rate target to 1%. Similar steps by the Fed may now be called for.

But there is another question that ought to be discussed. When the Fed reduced interest rates in 2002-03 because of the uncertainty created by the pending decision of the US government about whether to invade Iraq, the Fed was probably right to take that uncertainty as an exogenous decision in which it had no decision-making role or voice. The decision to invade or not would be made based on considerations over which the Fed rightly had no role to evaluate or opine upon. However, the Fed does have a responsibility for creating a stable economic environment and eliminating avoidable uncertainty about economic conditions caused by bad policy-making. Insofar as the current uncertain economic environment is the result of deliberate economic-policy actions that increase uncertainty, reducing interest rates to cushion the uncertainty-increasing effects of imposing, or raising, tariffs or of promoting a trade war would enable those uncertainty-increasing actions to be continued.

The Fed, therefore, now faces a cruel dilemma. Should it try to mitigate, by reducing interest rates, the effects of policies that increase uncertainty, thereby acting as a perhaps unwitting enabler of those policies, or should it stand firm and refuse to cushion the effects of policies that are themselves the cause of the uncertainty whose destructive effects the Fed is being asked to mitigate? This is the sort of dilemma that Arthur Burns, in a somewhat different context, once referred to as “The Agony of Central Banking.”


8 Responses to “Yield-Curve Inversion and the Agony of Central Banking”

  1. 1 Biagio Bossone August 17, 2019 at 1:48 am

    David, thanks for this new piece as brilliant and provocative as always.

    You conclude with a deep question, indeed a dilemma. Let me try to address it by offering a few comments. BTW, I have struggled myself with that question as a governor of the central bank of a very small state (with fully-fledged democratic institutions and an advanced economy), where the inherently close relations between institutions and among people do complicate even further the search for the right balance between central bank’s autonomy and the rule of democracy.

    Back to your dilemma between the Fed trying to mitigate the effects of government policies that increase uncertainty, on one side, and refusing on the other to cushion the effects of policies that are themselves the cause of the uncertainty.

    It seems to me that if the Fed followed the first option, it would definitely stay within, and well serve, its own mandate to preserve overall economic and financial stability. There would be nothing wrong with following this option, and in fact I would even say it would be quite an appropriate decision to take in so far as by doing so the central bank would 1) ensure, to the extent that it can, the most conducive environment for the policy choices of a democratically elected government to be implemented as effectively as possible, and 2) mitigate the negative effects that government policies might have on the economy in terms of inflation and employment, and financial instability.

    On the other hand, if the Fed were to pursue the alternative option, it seems to me that it would be playing plain “politics”: refusing to cushion the effects of government policies on economic uncertainty basically amounts to the central bank taking a political stance on those policies. Those policies might be right or wrong, but that is not the issue and certainly it is not the job of the central bank to respond to those policies based on its judgement on their righteousness or wrongness.

    Whether Trump’s trade attitude towards China will or will not ultimately bring the expected results in terms of US citizens’ welfare is for the US citizens themselves to judge, not a Fed’s task. The President has been elected by his peers and carries a full political mandate because of that, which he is expected to exercise according to the constitutional powers and limitations. Now, I am not at all a Trump sympathizer, but in point of democratic rule I don’t think the Fed should be asked to mitigate or hinder his policies since they cause uncertainty.

    And, I would argue, the economic uncertainty caused by government policies should not be invoked as a reason for any unelected agency to interfere with those policies. Moreover, behind those policies there may be motivations that go beyond pure economic reasons and involve other vital issues like international balance of power, national security, etc. Why, and in the name of which principle, should a financial regulator decide to step in and against those policies?

    Now, just to use trade policy as an example, my arguments so far do not prevent the Fed from intervening publicly and expressing its technical opinion on the President’s trade policy and its implications for national (economic, not political) welfare. Yet, when it comes to acting, the Fed should stay within its mandate and ensure this is served as effectively and transparently as possible.

    Wouldn’t such understanding and application of the democratic rule offer a useful compass to determine the perimeter of the Fed’s power and autonomy? Or am I missing something?

    I am much interested in knowing your view on this. Thanks again!


  2. 2 Benjamin Cole August 17, 2019 at 6:30 pm

    I agree with Bossone, above. The Fed’s job is not to undercut the president who may be following a poor economic policy from a macroeconomic standpoint. Suppose there are legitimate national security reasons behind Trump’s policies?

    Beyond that, the financial media has vastly overblown the scale of Trump’s tariffs. A 10% tariff on $300 billion amounts to a 30 billion dollar tax increase. The US in 2019 will collect $3.9 trillion in taxes.

    This financial media obsession with Trump’s tariffs reflects the very powerful influence on narrative that multinationals have. Multinationals can pour unlimited funds into media, lobbying, academia, think tanks, and even directly into political campaigns.

    The Federal Reserve should do all that it takes to keep the economy expanding towards a nominal GDP target.


  3. 3 Frank Restly August 25, 2019 at 8:14 am


    “Insofar as the current uncertain economic environment is the result of deliberate economic-policy actions that increase uncertainty, reducing interest rates to cushion the uncertainty-increasing effects of imposing, or raising, tariffs or of promoting a trade war would enable those uncertainty-increasing actions to be continued.”

    If tariff rate changes increase uncertainty, then why don’t interest rate changes also increase uncertainty?

    Simple example:
    I run a firm that provides insurance for various clients.
    I collect premiums from my various clients.

    My neighbor runs a firm that leases painted pictures to various clients.
    He collects monthly payments for the paintings that he leases.

    If I start raising the price of the premiums that I charge, and my neighbor starts lowering the monthly payment that he charges, has overall economic uncertainty or volatility changed at all?

    Sure, the relative prices of both goods have changed – my insurance has become more expensive relative to my neighbor’s leased paintings, but if anything, overall economic uncertainty has increased.

    To clarify – my firm is the U. S. federal government and the premiums that I collect are taxes.

    My neighbor’s firm is the U. S. central bank and the monthly payments that he receives are interest payments.

    If the uncertainty regarding tariffs is strictly based on the notion that economic policies instituted by one political regime can be undone by another, then ANY economic policy instituted by government (tax, spending, regulation, other) is subject to the same uncertainty.

    And just as government policies can be instituted and then undone (through a political process), central bank policies can also be instituted and then undone (albeit through an administrative process).

    “When the Fed reduced interest rates in 2002-03 because of the uncertainty created by the pending decision of the US government about whether to invade Iraq…”

    That is one interpretation. Another is that the Fed reduced interest rates in 2002-2003 in preparation for the pending decision by the US government to invade Iraq and Afghanistan and the subsequent borrowing by the US government needed to fund those invasions.

    Cloaking federal reserve decisions around “reducing uncertainty” (at least to me) obfuscates several things:
    1. The central bank can be forward looking
    2. Interest rate decisions by the central bank have implications for the federal government’s fiscal position


  4. 4 Egmont Kakarot-Handtke September 23, 2019 at 9:51 am

    Just for the record

    Sri Thiruvadanthai refers to the Levy/Kalecki equation. This is misleading. See

    The Levy/Kalecki Profit Equation is false

    Egmont Kakarot-Handtke


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About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey’s unduly neglected contributions to the attention of a wider audience.

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan

Follow me on Twitter @david_glasner


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