The Unintended Consequences of a Flatter Yield Curve
It was supposed to be easy. When the Federal Reserve started hiking the federal funds rate, longer-term interest rates would rise. After all, they were at very low levels, restrained by a low-term premium. The “Greenspan conundrum” of the past two cycles, when long rates failed to respond in line with higher short rates, couldn’t happen a third time in such circumstances.
But it didn’t work out that way. Short rates continue to gain on firming expectations of tighter Fed policy while long-rates stubbornly track sideways. As a result, the yield curve continues to flatten, raising fears of recession. What’s going on? Are the fears valid?
No, the yield curve does not yet signal recession. But it does suggest the economy remains mired in a low rate environment for the foreseeable future, which restricts the ability of the Fed to raise the federal funds rate.
Think about a decomposition of longer-term interest rates into three components -- the expected path of real short-term rates, expected inflation and the term premium, or the extra return required by investors to hold long-term bonds over short-term ones. Investors need to be compensated for the risk of holding long-term bonds.
There are reasons why all of these components remain depressed. First, the neutral real rate of interest arguably remains very low, failing to rise despite economic gains in recent years. Second, expected inflation might be falling. And third, there is arguably more certainty about the path of short-term rates, presumably an artifact of the Fed’s communication strategy. In effect, the central bank depresses the term premium by limiting the uncertainty surrounding monetary policy.
We shouldn't be surprised by the flattening yield curve. That is what typically happens during tightening cycles and there was no reason to think it would not be the case this time. Nor do I think that the flattening to date is warning of a recession just yet. It is the inversion of the yield curve that signals recession (this is especially the case if the Fed continues to tighten after the yield curve inverts). For example, the curve was extremely flat during the second half of the 1990s, a stretch of high growth. Only late in that period did the yield curve invert, finally foreshadowing the 2000 recession.
Still, I doubt the Fed would have expected it to flatten this much, foreseeing instead more of an upward shift of the entire yield curve. And the failure of such an upward shift to materialize has policy implications.
First, it suggests that the Fed’s longer-run rate projection, or the terminal rate of the hiking cycle, remains too high. The central bank has less room to move the short end than it currently believes. Failure to recognize this could cause overtightening, pushing the economy into recession.
Second, the Fed should be wary of embracing the idea that the stubbornly low long rates reflect easy financial conditions that require central bankers to correct via substantially higher short-term rates. This would become essentially an effort to force longer rates higher and would invite the Fed to invert the yield curve from the short end. Again, this would likely overtighten financial conditions with recessionary implications.
Third, the Fed needs to guard against the possibility of declining inflation expectations. Indeed, central bankers are sounding the alarm. For instance, Chicago Federal Reserve President Charles Evans warned this week:
Why might inflation expectations have drifted down? The FOMC’s 2 percent inflation target is a symmetric one—that is, the Committee is concerned about inflation running either persistently above or persistently below 2 percent. One concern I have is that the public instead thinks the Fed views 2 percent as a ceiling that it aims to keep inflation under.
Evans believes that policy makers need to more actively communicate that the inflation target is truly symmetric, with outcomes of above 2 percent as likely as inflation that is lower than that.
Arguably, though, the Fed only reinforces expectations that 2 percent is a ceiling with its commitment to rate hikes even as inflation remains below that level. In fact, monetary policy makers appear dead set to continue rate hikes next month, and into 2018. The message sent is that they stand ready to snuff out any expansion that threatens to push inflation above 2 percent.
If the Fed wants higher long-term rates, and with them a steeper yield curve, it may need to hold back on further interest rate hikes until inflation surpasses the target. This might not only boost inflation expectations, it could also create additional uncertainty about future monetary policy, thus pushing up the term premium.
For the time being, however, the Fed appears more focused on the risk that the economy will soon surpass full employment, allowing inflationary pressures to gain strength. Therefore, unless the neutral interest rate starts rising more aggressively, it seems likely the economy will remain stuck in a low interest-rate environment.
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