Is the Federal Reserve Responsible for the Flattening Yield Curve?

August 1 2018

The Federal Reserve is, as is commonly explained, raising short-term interest rates. As a consequence, the yield curve flattens. After all, short-term interest rates increase where long-term interest rates remain equal. The trick is, being the Fed, to not raise interest rate too quick but neither too slow. Raising rates too fast would mean that the growing U.S. economy would be dive into recession, whereas raising rates too slow would mean that inflation results. While that might sound plausible to a casual observer, it is unfortunately far from true. The Fed does not “create” a crisis by raising interest rates “too fast.” Better yet, even far before the Fed even existed, we can observe inverted yield curves before a crisis would hit. This means that the Fed has far less influence and power over the yield curve than the financial press is currently assuming to be true. And this also means that the Fed can do surprisingly little about this recent trend in global capital markets.

The Yield Curve and Recessions Before the Fed Was Created

Two Irish economists – Stefan Gerlach of EFG Bank and Rebecca Stuart of the Irish central bank – looked at the spread between the long-term and short-term interest rate before the founding of the Federal Reserve in 1913.

To do so, they took the data from the National Bureau of Economic Research (NBER) from 1857 onward, more than fifty years before the founding of the Fed. As a proxy of the short-term interest rate (nowadays we would use the 2-year or 3-month T-Bill), they used the “call money rate”, whereas for the long-term interest rate they took the yield on railroad bonds (of high quality). This was the result:

SOURCE: VOXEU, GERLACH AND STUART

So, the Same Thing Happened Before the Founding of the Fed

In the above chart, we can observe that the short-term rate (the blue curve “call money”) on various occasions exceeded – according to a cyclical pattern – the long-term rate (on high-quality railroad bonds). If we would put – as a figure of speech – the NBER chart on top of the above chart (which indicates recessions, basically a dummy yes/no variable), we would see that an inverted yield curve would predict a recession every single time, even in the 19th century far before the Fed had even been designed, let alone created.

According to the authors themselves: “[T]he term structure contained information about the likelihood of a future recession even before the establishment of the Federal Reserve. That suggests that the information content does not arise solely as a consequence of countercyclical monetary policy.”

The Fed Has Less Influence and Power on Monetary Affairs Than Many Think

This means that the Fed, despite its intended “monetary normalization,” can change little about the current trend (the current trend being a flattening yield curve while we are rapidly approaching a renewed recession).

The idea that the Fed can simply postpone rate hikes and prevent a recession by doing so, is simply nonsense. Another often-heard notion, is the notion that the Fed has learned from its mistakes made in the past with other recessions and will this time around do everything to avoid “raising rates too fast.” This notion is equally fallacious. Whatever the Fed may do, the yield curve will invert: rate hikes or not.

All this while at the same time gold prices, more or less as expected, have been under downward pressure and are close to falling below the $1,200 per troy ounce barrier. This implies that we presently, and anytime soon to an even greater extent, can buy gold against an interesting discount. Gold is cheap. And let us be honest: selling your gold at this point in time is probably the least clever you could decide to do given the fact that we are on the eve of the finale of the current bull market in stocks.

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