Interest Rate Update

After a rise in long-term interest rates earlier this fall, they have fallen back down a bit over the past week or two. Meanwhile, short term rates have been on a steady upward march all year. The result is that there is now virtually no difference between long-term interest rates and short-term interest rates. The chart below illustrates.

As you can see, it is rare for short-term interest rates to be as high as or higher than long-term interest rates, a phenomenon known as an “inverted yield curve”. And unfortunately, those episodes have historically corresponded to periods immediately preceeding a recession. (The US experienced recessions in 1982, 1990, and 2001.)

There are a few possible reasons for that correspondence. First, it is likely that low long-term interest rates (at least relative to short-term rates) are the result of some pretty pessimistic thinking on the part of bond market participants. Low long-term rates suggest that they think that the economy is going to slow, which will cause the demand for long-term borrowing in the economy to fall, and which will force the Fed to lower short-term rates in the not-too-distant future.

Secondly, banks make a lot of their money by borrowing at lower short-term rates and lending at higher long-term interest rates. If that differential disappears, then the financial incentive to lend money disappears. And as banks lend less money, the economy tends to slow.

So I would put this in the category of Not-Very-Good-Signs for the economy in 2006.


UPDATE: For more details about the phenomenon of the inverted yield curve, see James Hamilton at Econbrowser.