Banging Drum

I almost always agree with Kevin Drum who is, among other things, a brilliant economist even thoug (or largely because) he didn’t study economics much in college.

But I don’t entirely agree with his one minute explanation of the importance of the yield curve for macroeconomic forecasting.

the ever-fascinating yield curve, which tracks the difference between long-term and short-term treasury bond yields. Normally the long-term yield is higher to compensate investors for the risk of the economy eventually going sour. But what if you think things are about to get sour really soon? Then you’ll bid down the price of short-term bonds, which increases their yield, and pretty soon long-term yield is less than the short-term yield. The yield curve has “inverted,” which suggests that investors are nervous about a recession hitting.

My comment

I think the yield curve story isn’t that simple really. First it always used to be an indicator of monetary policy. The Fed controls short term interest rates. When it chooses contractionary monetary policy (to fight inflation) it sets high short term rates. The long term rates don’t move up as much, because investors are sure the fed will relent after inflation falls. This was always the normal pattern.

Back in the good old days (before 1999) an inverted yield curve occured if and only if the Fed was cracking down to fight inflation. Notice the 90s. The yield curve was very close to flat during the whole late 90s boom. What was happening was the Fed was pressing gently on the brake worried about inflation & the magic of the internet (or foolish dot com mania) kept the economy booming. The alarmingly exuberance caused the fed to raise rates in 2000 (not at all trying to prevent Gore from being elected nooo Greenspan would never do such a thing). And the bubble burst.

Notice also the S&L recession happened without a dramatic yield curve inverstion. There were these two really smart time series econometricians Stock and Watson who had a model which “predicted” recessions really well. In 1990, it never said a recession was coming. Their explanation was that it detected inflation fighting recessions — that from wwII until 1990 recessions occured when the Fed decided to cause a recession to fight inflation (the also very smart Romer and Romer noted that recessions occured after statements like “we have to cause a recession to fight inflation” appeared in the Fed open market committee minutes).

I’d say a steep yield curve shows a fed desperately trying to pump up the economy and, therefore, pushing short term rates far below normal (long term rates being equal to the short term rate investors think is normal plus a small term premium cause they know they don’t know what is normal).

So the graph shows desperate efforts to stimulate when Republicans are in the White House or Bernanke or Yellen is chair (not that Saint Alan Greenspan was partisan or anything). The flattening just shows that the FOMC is no longer stimulating as hard as it can by keeping the short term rate at 0.25%.

Also the long term rate which investors now guess is normal is very low. That is called secular stagnation not incipient recession. Looking at short and long rates separately helps. Both are very low now. In 2000 both were high as the Fed was fighting the boom (a tiny bit too hard but it lead to a tiny miniscule recession). 2008 was a strange strange time when both short and long term interest rates were almost zero and yet demand was low. Then zero was not low enough. Now the FOMC thinks zero interest is a bit too low.

So I don’t agree with your story.
In general economic downturns cause low interest rates both directly and through active monetary policy. The yield curve slopes up because investors fear the Fed might decide to fight inflation, not because they fear a recession will just happen and it will drive up interest rates. The causation is high interest rates cause recessions not the other way.

In 1990 and 2008, I’d say the issue in 1990 and (much more so) in 2008 was people expected long lasting trouble, so persistenly low short term interest rates, so long term rates were low too. In 2000 and all recessions post WWII and pre presidents Bush the yield curve inverted because short term interest rates were high because the Fed was pressing on the brake.