How can the Fed manage to survive a recession after rate hikes and yield curve inversion?It hasn’t been long since we experienced a recession. The US experienced a two-month-long recession – the shortest and deepest ever – during March and April 2020, and has been on an expanding trend since then. The massive amount of fiscal stimulus helped pull the economy out of recession in just two months. But this stimulus, coupled with global supply chain problems during the recovery, also pushed the consumer price inflation number to a 40-year high of 8 percent.
The start of the second term of US Federal Reserve Chairman Jerome Powell in November 2021 sparked the Fed’s “currency-to-inflation” strategy. Since then, inflation numbers have been rising higher and the Fed’s monetary policy stance has become more bullish by the month. The Fed made its first liftoff in March 2022 and released its new revised economic projections on the same day. The Fed’s dot-plot – a compilation of individual FOMC officials’ estimates for the optimal federal funds rate (FFR), the central bank’s key short-term interest rate – showed that most of them saw the FFR as being above their longer-run level. had guessed. (2.4 percent) by the end of 2023. The long-run level is often thought of as the neutral level of the policy rate – a level that does not stimulate or tighten the economy. Thus, a policy rate above the neutral level means a real monetary “constriction”, leading to economic downturns and often recessions.
Keep in mind that this scenario is considered “optimal” by FOMC members. Ideals and practices differ, as both Chair and Vice Chair nominee Lyle Brainard commented that the rate would first be neutral by this year, and then the Fed would decide whether to go ahead next year. We will see a lot of growth in May and June this year, including some big moves (possibly an increase of 50 basis points, with 1/100th of a percentage point). This situation is no longer surprising, as expectations are mostly priced in market returns.
Still, what if the Fed decides to push rates above neutral? Will doing so mean that they are ruining the economy, leading to a recession? Historically, the Fed has been far ahead in many respects, but there have also been episodes when the Fed avoided a recession after a series of rate hikes. These cases were in 1967, 1984 and 1995 – mentioned when President Powell gave a speech at the National Association for Business Economics (NABE) conference.
How did the Fed manage to survive the recession during those years? The common feature was the Fed’s nimble response to the economic downturn. Key indicators slowed down as inflationary pressure eased. The Fed cut rates less than six months after raising rates. In the years 1984 and 1995, rates were cut after the Fed pushed the FFR above neutral. Rate cuts in 1967 enabled the US economy to avoid a recession as inflation slowed. But the Fed had to come up with a series of aggressive rate hikes in 1969 despite the economic downturn as inflationary pressures were mounting. The economy went into recession in 1969-1970.
The cases of 1967 and 1969 give lessons for today. If continued rate hikes and supply constraints are relieved and eventually push inflation down, the Fed may not risk driving the economy into another recession. After the FFR is neutralized, whether the Fed’s flexibility pays will be determined next year.
Is the yield curve inversion different this time?
Other bearish fears are due to the recent yield curve inversion – a phenomenon in which short-term bond yields rise above long-maturity bond yields. This phenomenon is unusual because long-term returns are worth a premium because they involve leaving today’s cash for a longer period. During the first four days of April 2022, the two-year Treasury bond yield exceeded the ten-year Treasury bond yield.
A yield curve inversion is often thought to be leading to a recession. The yield of long-term (ten-year bonds) is a function of the economic cycle, growth and policies. Short-term (two-year bonds and below) yields usually depend on monetary policy. Yield curve inversion means that monetary policy is too tight for the economy to tolerate, and it has been the case that such conditions have preceded recessions in economic history.
Despite its characteristics, many have argued that the yield curve inversion may not be a viable indicator of an impending recession. In 2006, a glut of global savings was proposed as a cause, but proved wrong when the global financial crisis struck. Yield distortion due to the Fed’s large-scale asset buying (LSAP, also known as “quantitative easing”) is another reason being suggested as a supporting argument for this timing separation. On the other hand, there are people like Larry Summers (former US Treasury secretary) and William Dudley (former New York Fed chairman) who still argue that the Fed is too late and a recession is inevitable. who is right?
I would like to suggest three criteria for deciding whether a yield curve inversion suggests an imminent recession in the future. First, episodes from the 1980s onwards show that the yield curve (with yield spreads of two to 10 years) inverted for more than four consecutive months before the recession. We observed yield curve inversion during 1998 and 2019, but the periods of inversion were 28 days and 3 days, respectively.
Second, a yield curve inversion must occur primarily through a decline in long-term yields to indicate a future recession. Such an indication means that monetary policy is too much to weather the economy, and also weighs on the sentiments of economic institutions.
Third, the yield curve must be sufficiently inverted — at least 20 basis points — to be a viable indicator of an impending recession. The yield curve was narrowly inverted during 2006, but the gap widened once again to 19 basis points. During the 1998 and 2019 episodes, the expansion of inversions to maximum value was only 7 basis points and 4 basis points, respectively.
Fear of recession is indeed on the rise but the recent inversion of the yield curve is still far from making it a leading indicator of recession. The Fed could raise its FFR above neutral and create additional fear. However, if inflation pressure eases and the Fed provides a way to respond quickly, it is likely that we will be able to avoid a recession during this episode.