A downward sloping yield curve is widely seen as a harbinger of recessions, and indeed has an impressive track record. The yield curve inverted before the last two recessions and is likely to invert again within less than a year, which naturally raises fear of another recession. Much commentary of late has noted that yield curve inversions, in 2000 and 2006, correctly signaled downturns soon thereafter. Given little evidence of large Philips curve inflation linkages, the argument goes, today’s yield curve flattening clearly signals that Fed policy tightening is a mistake.
We agree that it is important to embrace insights from recent economic history, even if they call key macroeconomic linkages into question. To our way of thinking, however, the fundamental macroeconomic error of the past three decades, was failing to appreciate that asset market excesses can deliver destabilizing dynamics, just as well as wage and price pressures. Learning lessons from recent history is important, but it is also important to consider carefully what those lessons are.
Today’s flat yield curve in part reflects the fact that the term premium is lower than it was in previous decades and that should affect the signal that we infer from the slope of the yield curve. When term premia were large, monetary policy had to be very restrictive to get a downward sloping yield curve.1 But today’s flattening yield curve shouldn’t imply as much recession risk as it did when the funds rate was so far above neutral as to make the yield curve slope down in spite of a big term premium.
We acknowledge that arguments along these lines were made when the yield curve last inverted, and the Great Recession followed two years later. In a recent Project Syndicate essay, Brad DeLong takes the Federal Reserve to task for refusing to learn this and other lessons from recent history as he concludes that the Fed should not let the yield curve invert. We applaud his focus on the recent past and his willingness to jettison conventional thinking. We simply think he has learned the wrong lesson.
Let’s go back to 2006 and imagine that Greenspan, seeing the inverted yield curve, decided to reverse course and cut the funds rate back to 3%, steepening the yield curve. What would have happened? The U.S. would likely have avoided the onset of recession in 2007 and the housing boom would have continued for a bit longer. Kindleberger reminds us that in the late stages of a bubble transactions get exponentially worse. Mortgage finance, in 2006, had become insane. If we had postponed the bursting of the bubble, the bust would have been even more catastrophic when it came. The key mistake was lax regulation and the Fed tightening too little in 2003 and 2004, not tightening too much in 2006.
The NASDAQ trebled from March 1998 to March 2000. Price to revenues for tech start-ups were infinite. They had no revenues! The tech wreck imposed deflationary forces on the economy. But how would that have been made better if the Fed had tightened less in 1999 and 2000?
The last two (or three) recessions were not caused by monetary policy tightening to offset wage and price pressures, but rather by financial market excesses. Easier monetary policy could have delayed these recessions, but at the cost of making them worse when they happened. DeLong reminds us that big bouts of inflation were MIA and catalogues the major deflationary swoons that appeared over the past several decades. Each of these swoons, however, resulted from the bursting of an asset bubble in the previous cycle. Once you link asset price excesses to subsequent deflationary headwinds, your sense of what constitutes appropriate monetary policy changes dramatically.
Right now we face little risk of major wage and price inflation, though with the fiscal stimulus put in train it is hard to be categorical about this. But if Chairman Powell were to stop or reverse tightening, fearing yield curve inversion, then already lofty valuations would be driven into a clearly unsustainable boom.
If we think that term premia are around zero, to say that the Fed must never let the yield curve invert is effectively to say that the Fed must never set the funds rate above neutral. That seems a crazy concept of neutral.
There is, of course, a serious downside to leaning against today’s building economic momentum. Real wage gains, disappointing for decades, are likely to remain so, if tighter money engenders a slowdown. Some might argue that distributional considerations are grounds to hold off on tightening. Clearly, income and wealth inequality are first order issues. Spectacularly perversely, the GOP just delivered major tax law changes that will make these imbalances much worse. But asking the Fed to both maximize the economy’s stable long run trajectory and to simultaneously improve its distributional performance, is asking too much of the central bank.
1. Suppose that we think that term premia are now close to zero in steady state. Then, roughly speaking, any time the funds rate is above neutral, the yield curve should slope down, which should happen about half the time.↩