Federal Reserve Chair Janet Yellen just had her last post FOMC meeting press conference as Fed Chair. Her comments revealed quite a lot about what she and much of the rest of the Fed believe will be in store for the economy next year. They see mostly smooth sailing ahead as interest rates slowly rise. This, despite one of the most telltale signs of recession ahead over the last 40 years – an inverted yield curve, or a negative yield spread. All five recessions of the last 40 years have been closely preceded by one.
The very last question Yellen fielded at the press conference had to do with the flattening curve, pitched by Bloomberg TV’s Michael McKee. McKee asked, “[D]o you think that there is any Fed blame or complicity in the flattening of the yield curve, and are you worried that there might be some sort of policy mistake built into that that could slow the economy?”
McKee’s question is especially relevant now because the spread between 30-year and two-year yields has, as of Dec. 15, hit another low not seen in the past 11 years. Her answer to the question though was not particularly original. Yellen said in response:
I would say that the current slope [of the yield curve] is well within its historical range. Now there is a strong correlation historically between yield curve inversions and recessions, but let me emphasize that correlation is not causation, and I think that there are good reasons to think that the relationship between the slope of the yield curve and the business cycle may have changed.
Basically, Yellen’s reasoning as to why this time is different is that an inverted yield curve is only a signal of recession when yields are higher to the point of causing recession. So it’s not the spread that matters, but absolute interest rates across the board. Since yields are still low across the board, an inversion won’t necessarily cause a recession.
The thing is, Ben Bernanke said the exact same thing on March 20, 2006, during which time the yield curve was essentially flat and about to invert, in a speech before the Economic Club of New York. Said then newly appointed Fed Chair Bernanke:
I would not interpret the currently very flat yield curve as indicating a significant economic slowdown to come, for several reasons. First, in previous episodes when an inverted yield curve was followed by recession, the level of interest rates was quite high, consistent with considerable financial restraint. This time, both short- and long-term interest rates--in nominal and real terms--are relatively low by historical standards.
This is essentially the same exact argument. In 2006, interest rates across the board were lower than they were historically before that, and so the inverted yield curve this time would not lead to any trouble. We all know how that turned out.
If Yellen’s and Bernanke’s reasoning before her were even slightly valid, the recession that began in 2007 would have been milder than the recessions that came before it because the other recessions before 2007 were preceded by higher interest rates across the board. But the Great Recession was, as its name suggests, more severe than the other four recessions that came before it, despite being preceded by the lowest across-the-board rates of the last five.
Perhaps it’s not the absolute rates that matter after all. The question now is, will incoming Chair Jerome Powell say the same thing, and will he be yet another incoming chair faced with an imminent recession, having no idea that it is at his doorstep?
