These Classic Charts Are Confounding Economists

A debate is raging on what the flattening of the yield curve and the Phillips curve mean for U.S. growth.
Illustration: Joe Melhuish for Bloomberg Businessweek

The new year in economics will be a tale of two curves that have mysteriously gone flat—the yield curve and the Phillips curve. Some economists argue that the uncurvy curves are sending a message that the U.S. economy needs more stimulus. The debate is likely to be a prime topic at the Federal Reserve when Jerome Powell takes over as chair in February, assuming the Senate confirms his nomination as expected.

For all the attention they’re getting, though, there might be less to the two flattenings than meets the eye. Skeptics argue that the risk of recession remains low and the possibility inflation will pick up is still high. Says Jim Paulsen, chief investment strategist at Leuthold Group LLC: “I agree they are considered big stories, but I think both are overblown.”

The yield curve is about the price of money. It shows the interest rates an investor can earn on U.S. Treasuries or other bonds of different maturities, with the shortest-term instruments on the left and longest on the right. The yield curve normally tilts upward, since rates tend to be higher for longer-term bonds, because investors demand a better rate as compensation for tying up their money for a longer period of time.

It’s a bad sign when the yield curve inverts to a downward slope—that is, long-term rates become lower than short-term ones. The higher rates on the left end of the curve indicate that the Fed is raising short-term borrowing costs, which chills the economy, while the lower rates on the right end of the curve indicate that long-term investors have low expectations for growth and inflation.

When the yield curve is steeply inverted, a recession almost always follows. Neel Kashkari, president of the Federal Reserve Bank of Minneapolis, explaining his dissent from the Fed’s December rate hike, wrote, “While the yield curve has not yet inverted, the bond market is telling us that the odds of a recession are increasing and that inflation and interest rates will likely be low in the future.” He said the flatness of the yield curve should discourage the Fed from hiking rates more “until it becomes clear that inflation is actually picking up.”

The potential flaw in Kashkari’s analysis is that the yield curve is still a long way from tipping over. Its current incline is historically associated with healthy growth. Says Leuthold’s Paulsen: “Until you actually invert, it says nothing about higher recession risk, at least historically. There really is a toggle switch for inversion.”

Liz Ann Sonders, chief investment strategist for Charles Schwab & Co., wrote in December that the stock market has turned in its best performances when the yield curve is sloped the way it is now, or even flatter. She called this the “sweet spot.”

It’s possible, of course, that the economy will slow and the Fed will keep cranking short-term rates higher. But that assumes a blunder by the central bank. Jan Hatzius, chief economist of Goldman Sachs & Co., told Bloomberg Television in December that long rates are likely to go up at the same pace as short rates in the coming year, leaving the yield curve no flatter than it is now.

In contrast to the yield curve, the Phillips curve slopes downward in textbooks. Named after the late New Zealand economist A.W. Phillips, it shows that inflation tends to be high when unemployment is low, and vice versa. That makes sense: Workers demand higher wages when the labor market is tight, and that spills over to the general price level.

The Phillips curve is a less reliable indicator than the yield curve, though. Since the last recession, contrary to the textbooks, it’s been flat, not sloped. Inflation has remained below the Fed’s target even though the unemployment rate was at an almost 17-year low of 4.1 percent in November.

If the Phillips curve is broken—that is, low unemployment no longer leads to high inflation—then the Fed can afford to keep financial conditions loose despite the tight job market. Fed Governor Lael Brainard, who tends to favor keeping rates low, argued in December that there’s more slack in the labor market than the headline unemployment rate would indicate because many people gave up looking for a job and were therefore not being counted. Those once-discouraged workers are a hidden source of new employment. “In the past few years,” she said in a December speech, “the job market has gotten so strong that many of these people have come off the sidelines—and many are now back at work.”

But the logic behind the Phillips curve remains sound. If the U.S. economy keeps creating jobs at its current clip, it stands to reason that eventually the labor market will get so tight that wage inflation will accelerate. That would be good for workers, but it would bolster the hawks’ case for extra rate hikes in 2018 and beyond.

The U.S. is far enough along in its economic recovery that people are speculating nervously over what will go wrong, and when. The Phillips curve and yield curve will be studied closely in 2018 to help forecasters see around the next bend in the road. 

    BOTTOM LINE - The debate over what the flattening of the yield curve and the Phillips curve mean for the U.S. economy is getting louder. The pessimists may be making too much noise.
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