In our last post, we noted that the yield curve is close to inverting, which is usually a sign that a recession is coming. We also said that actions of the Federal Reserve Board may be a factor in causing the inversion.
So what does the Fed think about a potential inversion? And what action will it potentially take to prevent one?
Federal Reserve Board Chair Jerome Powell is not especially concerned about the inverting yield curve. He said at a recent news conference that an inverted yield curve has preceded recessions in part because “inflation was allowed to get out of control, and the Fed had to tighten, and that put the economy into recession. It’s really not the situation we’re in now.”
While interest rates in the U.S. have been increasing, they remain ultralow in other parts of the world, which may be boosting demand and prices for long-term Treasuries, while pushing yields lower.
“Both the European Central Bank and the Bank of Japan have monetary policies opposite those of the U.S. Fed. Long-term interest rates in Europe and Japan have hovered near zero, or even below,” Burton G. Malkiel wrote in The Wall Street Journal. “These yields have made U.S. Treasury bonds extremely attractive, especially since the dollar has been increasing in value.”
Regardless, when the gap between short- and long-term bond-yields narrows, Powell said, bank profits weaken and the risk of financial instability increases. That’s because banks pay short-term rates on deposits and earn long-term rates on loans. The Fed will “be watching carefully,” he added, to ensure that banks aren’t engaging in risky behavior, such as the behavior that caused the Great Recession.
If investors become concerned about a potential recession, or if they otherwise become concerned about the safety of their equity investments, they may put more money into long-term government bonds, which are considered to be a safe investment. That would also cause the yield curve to flatten, as increased demand would result in a lower yield.
The growing number of retirement-age Americans may increase demand for long-term bonds, regardless, as retirees seek to protect their portfolio during retirement.
While Powell may not be concerned about the flattening yield curve, several other Fe
d governors are expressing their concerns. Atlanta Fed President Raphael Bostic said he wants to avoid an inverted yield curve, even if it means slowing the Fed’s rate of interest-rate increases. Dallas Fed President Robert Kaplan, St. Louis Fed President James Bullard and Minneapolis Fed President Neel Kashkari have also expressed unease about the yield curve inverting.
So, with the economy booming, the Fed is expected to continue to raise rates regularly and possibly even accelerate the process. But doing so could potentially cause the yield curve to invert.
It’s yet another example of the unintended consequences of the Fed’s quantitative easing program. You can’t purchase trillions of dollars’ worth of bonds without unintended, and sometimes harmful, consequences.