(MENAFN - Gulf Times) Is an inverted yield curve the same old trusty recession signal Wall Street has come to lean on over the decades, or is it just part of the Federal Reserve's plan to avoid one next time around?
Fed officials are split on the question, according to a record of their December policy meeting published last week. The account revealed a lengthy discussion about the recent shrinking of the spread between short- and long-term market interest rates.
In the past, when short-term rates have risen above long-term rates, a recession has often been not far behind: The spread between two-year and 10-year US Treasury note yields has collapsed to the lowest since October 2007, when the country was heading into the deepest contraction since the Great Depression.
While some policy makers are worried the yield curve may be sending the same message again, others think it may be different this time. One piece of evidence in support of the more benign interpretation of the flattening yield curve: Fed officials' own projections of appropriate policy show that it may invert in 2020, when they expect to raise short-term rates above their longer-run neutral levels to cool down an overheating economy.
During the December 12-13 meeting of the rate-setting Federal Open Market Committee, at which officials lifted the policy rate by a quarter point to a range of 1.25% to 1.5%, 'some were concerned that an inverted yield curve hadn't lost its predictive power as a recession warning, according to the minutes.
However, 'a couple of other participants viewed the flattening of the yield curve as an expected consequence of increases in the committee's target range for the federal funds rate, and judged that a yield curve inversion under such circumstances would not necessarily foreshadow or cause an economic downturn.
The minutes went on, saying 'it was also noted that contacts in the financial sector generally did not express concern about the recent flattening of the term structure. Projections released at the meeting by the 16 policymakers on the FOMC showed a median forecast that the target range for rates would be 3% to 3.25% by the end of 2020, before bringing them back down to a 'neutral level of 2.75% sometime thereafter.
That implies the Fed's actions might invert the yield curve, and market prices are starting to line up with such a scenario. Forward rates derived from swaps linked to the Fed's benchmark overnight rate are already close to inverting between three and four years out - right where the FOMC's projections imply they could if all goes according to plan.
The logic of the projections goes like this: By 2020, the unemployment rate will be so far below its 'neutral level that it will start putting upward pressure on inflation, which means Fed officials will need to have tight policy with rates above their estimate of neutral to keep the inflation at bay. Eventually, if the forecasts pan out, they would then bring rates back down to the neutral level once the unemployment rate rises back to what they see as a more sustainable, non-inflationary level.
That interpretation is a far cry from the old wisdom about yield-curve inversions. They have tended to precede recessions because in the past, as the economic outlook deteriorated, investors would increasingly bet that the Fed's next move would be to switch from rate hikes to rate cuts. The big difference now is Fed officials' own projections: They only began publishing them in 2012, and they potentially offer investors a less alarming way to think about why the yield curve might invert.
A few Fed officials have voiced concern over the flatter yield curve, including Minneapolis Fed President Neel Kashkari, who cited it directly in his dissent against the December rate hike, alongside worries about low inflation.
Still, the December minutes don't suggest that worry is widely shared on the FOMC, said Michael Feroli, chief US economist at JPMorgan Chase & Co in New York.