We are in Uncharted Territory
The inverted Treasury yield curve: we are in uncharted territory
– by New Deal democrat
We passed a significant anniversary last week: the spread for the 10-year minus 2-year Treasury has been inverted for over 2 years (blue in the graph below). The 2-year minus 3-month Treasury spread has also been inverted for 20 months (red):
Why is this significant? Because neither spread has been inverted for as long as they have at present without a recession having already started. In fact in a few cases the recession has been close to ending, or even already ended!
The closest case was when the 10-year minus 2-year spread inverted at the start of 2006. A recession did not start until 23 months later.
What happens now? There is no good historical analogy. We are in uncharted territory.
As I have pointed out a number of times in years past, the yield curve is not infallible. There was a significant yield curve inversion in 1966-67 without a recession occurring. On the other hand, there were no yield curve inversions at all between 1933 and 1960, and yet there were 6 recessions during that time, including the very deep 1938 recession:
Since the Fed began to more actively manipulate the Fed funds rate in the 1950s, typically a 2% or greater increase in the rate within a year has triggered a recession (graph below subtracts 2% so that a 2% YoY increase shows at the zero line):
There were two false positives (1984 and 1994) and one false negative (2000, when a 1.75% increase in the Fed funds rate over 12 months preceded a recession).
Needless to say, the very aggressive Fed funds rate hikes of 2022 did not trigger a recession in the 2 years since.
In the case of 1938, it is thought that a very deep fiscal retrenchment was the main trigger for that recession. In the case of 1966, LBJ’s aggressive “guns and butter” fiscal spending kept the economy stimulated enough to avoid a recession (blue line below, showing Federal spending YoY):
And in 2022-23, the unspooling of pandemic-related supply chain bottlenecks more than outweighed interest rate tightening (as shown by the red line below, in which commodity prices declined on average almost 10% during that time):
It just goes to show that no metric is infallible.
As for what happens now that both the stimulus spending and supply chain unspooling are done, there are two realistic possibilities:
1. Because interest rates remain very elevated compared to before 2022, their constricting effect has just been delayed.
2. Because interest rates are even with or below where they were when the supply chain unspooling ended, they are no longer restrictive relative to that period, so the economy should continue on trend.
As I said above, we are in uncharted territory. There is no on point historical analogue. That’s why I am watching the leading sectors of manufacturing and construction so closely this year. We’ll get updates on both of them for June later this week.
Lends credence to the economic philosophy that monetary policy is not a very effective tool in steering the economy, controlling inflation, or maximizing employment. Higher Fed funds rate may reduce demand, but can also reduce supply by curtailing investment in new production. Businesses may also raise prices to compensate for higher interest payments on lines of credit. Higher interest payments from the treasury and central bank are equivalent to stimulus payments to the private sector which can boost demand. In summary, when the Fed inverts the yield curve the outcome is far from certain. The empirical data tends to support this.
Mark:
Close. If you wish to increase price? Reduce inventory, change packaging, Limit capacity. Or just be brutal and say we are raising prices when there are no short-term options. This also occurred in 2008.
Bill, I wonder how many people in Congress (or in the general population) know what is meant when the Fed raises/cuts interest rates. What interest rate are they setting? What is the function of that interest rate? Why is that interest rate needed? How does the Fed set the interest rate? My job was in power plants and finished doing high voltage electrical engineering. The most important thing I learned in my career; you can’t fix something if you don’t know how it works. So when I started studying economics, I started with the basics- how does the money system work.
Mark:
New Deal democrat To be absolutely clear: the PCE inflation gauges, just like the CPI measures, show that excluding housing, inflation is already under the Fed’s 2% target. And if we include more current rent and house price measures, it is even a little lower than that.
Ex-housing, PCE inflation, like CPI inflation, is under the Fed’s 2% target
Read New Deal democrat as he has some good commentary. I will get back to this. However, my time is limited right now.