A Yield-Curve Inversion Isn't a Done Deal
The Federal Reserve reaffirmed its 2018 projected path of an additional three 25 basis-point rate hikes at this week’s Open Market Committee meeting. I wrote last week that the announcement set the stage for an inversion of the yield curve by the end of next year.
This “yield curve will invert in 2018” story rose to prominence in recent weeks as many analysts made similar predictions. Where did this forecast arise from and under what conditions will it come to pass? Why might the yield curve steepen instead?
Historically, the yield curve flattens during monetary tightening cycles, a pattern repeated this cycle. The argument for continued flattening and then inversion is fairly straightforward. Long-term rates have remained pretty stable since the Fed began tightening, a result of a low neutral real interest rate, low inflation expectations and a low term premium. Meanwhile, short-term rates move steadily higher. Assuming long rates remain held down, just a handful of rate hikes -- as the Fed anticipates -- would invert the yield curve.
This assumes the Fed doesn’t get cold feet soon. Indeed, it seems like the feeble inflation numbers would prompt a stronger reevaluation of policy as the data weaken the argument for continued rate hikes in the near term. But the Fed has not been deterred, and this should come as no surprise. For more than two decades the central bank has erred on the side of higher unemployment over faster inflation.
There is no reason to expect this time to be different. Some policy makers such as Chicago Federal Reserve President Charles Evans believe the Fed should explicitly allow for inflation in excess of 2 percent to shore up expectations. Yet, such a suggestion is difficult to reconcile within the Fed’s inflation targeting framework, in which the central bank does not attempt to make up for past inflation misses. That's why central bankers aim to hit the target from below.
To be sure, past performances are no guarantee of future ones. Facing an environment of persistently low wage growth and inflation, the Fed could determine that the natural rate of unemployment, or the non-accelerating inflation rate of unemployment, known as NAIRU, is sharply lower. The reduction of the Fed’s estimate of NAIRU in recent years is a step in that direction. Further reductions, if they happen soon, could lessen the Fed’s commitment to near-term rate hikes and slow and stall the rise in short rates. Still, I tend to believe that Fed would hesitate to veer from its path as long as the economy continued to post solid numbers consistent with further declines in the unemployment rate.
The one-two punch that would help steepen the yield curve and avoid inversion would consist of a sharp downward reversion to the Fed’s estimate of NAIRU in addition to more explicit allowance of above-target inflation. This could lower expectations for rate hikes, and would depress the short end of the yield curve. It would, at the same time, create greater uncertainty over the path of inflation, thus lifting the term premium and with it the long-end of the yield curve. Basically, the Fed needs to just back off and let the economy run.
Similarly, if growth unexpectedly slows, market participants might reasonably anticipate the Fed could switch gears and ease policy. This would take pressure off the short end of the yield curve, allowing for steepening (recall the steepening of the yield curve in 1995, for example). Or perhaps the opposite happens. Activity accelerates on the back of productivity, boosting the neutral rate, while the Fed retains its current rate path. That could steepen the curve from the long end. And yet another path to avoiding inversion is that the Fed simply pauses rate hike after flattening the yield curve.
In short, while investors increasingly look for a yield-curve inversion next year, much can change to alter that forecast. The direction of yield curve, like policy, is not on a preset path.
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