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March 7, 2006
How long will the inversion last?
The yield curve is quite flat at the moment. From 2 to 30 years out, it is actually inverted by 4 basis points as I write. That may not sound like much, but if you're in the business of borrowing short and lending long, it's not a pleasant sight. Inverted yield curves are said to portend recession. Could it also portend a soft landing?
If you're inclined to think that the economy is on the right track and the expansion is not yet over, you're probably thinking that the inverted yield curve will be short-lived. If you are optimistic about such things, the odds are that you look for the long rates to move up rather than the short rates move down, at least in the next few weeks and months.
Lately, the 10 year has shown some signs of moving above its mid-2004 level. When you look at the behavior of the rate over the last couple years, the rise has been slow and steady after a rather precipitous fall in 2004. Clearly the Fed has been trying to stay ahead of the curve. Whether they got too far ahead and where they will go from here is the subject of some discussion. But St. Louis Fed President William Poole is optimistic about the potential for growth and wants to keep the Fed ahead of the curve. (CNN Money)
"Should we get data in the coming months that are consistently strong, particularly if there are substantial upside surprises, then that says we're going to have to step a little harder on the brake," St. Louis Federal Reserve President William Poole told Reuters.
He said the opposite will hold if the data were on the soft side. But he didn't sound very convinced this is in the cards and doubts a cooling housing market could undermine the expansion as some private sector economists have warned.
"My sense is there is a great deal of momentum in the economy. I don't think that it is momentum of the sort that is going to run us off the rails," Poole said, explaining he doesn't think the growth pace would create widespread labor market shortages.
"But I think it is momentum of the sort that says we're going to keep rolling down the expansion here, and you're not going to stop this freight train easily."
This means higher short term rates. If the Fed is wrong, and the growth never materializes, the yield curve will invert further, policy will overshoot, and recession is possible. But, if the Fed is right, the long yields will rise in concert with the short rates until inflation stabilizes and the Fed feels comfortable taking its foot off the brake--the much anticipated "soft landing."
Of course, if the Fed waits too long and inflation takes hold, long rates could rise because of higher inflation expectations. This means even higher short term rates later, possibly another more serious inversion, and a hard, perhaps bumpy, landing.
At the moment, I would ascribe the slow uptick in the long bond yield to be a return to somewhat normal real interest rates (after years of extremely low real rates). Long rates are following the short rates upward, not as fast as some would like, but they are inching up. Prospects for economic growth, not growing inflation expectations, seems the more likely explanation. In the end, we know only marginally more than we did a few months ago when we had the same discussion, but nothing has caused me to dramatically alter my priors. Future policy moves will be data dependent. A couple more rate hikes are likely, and now the 10 year looks like it might keep up a little better. As long as the adjustment doesn't come too rapidly, a soft landing is possible. We might even be experiencing it now. (Is 1.6% GDP growth for a quarter a soft landing?) Ideally I'd like to see some spacing out of the rate hikes (every other meeting perhaps) as things wind down to really grease this economy back onto the runway. But then, with the economy as in an airplane, I'm pretty critical of the landing.
For further reading, I suggest this speech given by Poole from a few months ago. In it he gives some historical perspective on the term structure and discusses implications for policymakers in the current environment. It's from last June, but it still reads well today. It is required reading in my MA level macro course.
UPDATE: Mark Thoma links to a speech by Michael Moskow, and David Altig offers some thoughts that parallel this post.
Posted by William Polley at March 7, 2006 4:10 PM
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