The nine-year economic recovery is dead. Long live the recovery.
The Federal Open Market Committee (FOMC), the Federal Reserve’s main policymaking body, meets this week to decide whether or not to raise interest rates. No matter what it does, the decision is likely to be criticized.
Since late 2015, the Fed has increased short-term interest rates eight times from (effectively) zero to a range of 2 percent to 2.25 percent. The expectation is for another increase, to 2.5 percent. The case for acting now, which seems supported by Federal Reserve Board Chairman Jerome H. Powell, is to avert higher inflation and to discourage financial speculation, fueled by low interest rates.
Just recently, a new Fed study, called the “Financial Stability Report,” warned that lenders have relaxed credit standards on more than $4 trillion of corporate debt. The report also found that prices of stocks, commercial real estate (say, office buildings) and farmland were high by historic measures. Prudence requires raising interest rates.
And yet, not everyone concurs. Some economists fear higher rates might trigger an economic slowdown or a recession. Wild stock market swings feed their anxieties.
By this view, the Fed shouldn’t press its luck. Inflation is near the Fed’s target of 2 percent. At last reading, the consumer price index was up 2.2 percent over the past year; the deflator of personal consumption expenditures was slightly lower, at 2.0 percent. There’s ample time to react if inflation worsens.
Meanwhile, the recovery is a powerful jobs program. We shouldn’t kill it. Remember, the unemployment rate among African Americans , usually in double digits, is a historically low 5.9 percent. Interestingly, President Trump, who has been highly critical of Powell, is in this camp, along with some liberals.
Hanging over the debate is a technical — but important — argument over the so-called “yield curve.”
The yield curve refers to the relationship between short-term and long-term interest rates, for example between a three-month Treasury bill and a 10-year Treasury note. Normally, long-term interest rates are higher than short-term rates because investors assume more risk by lending money for, say, a decade rather than for three months. (“Yield” means interest rate or some other measure of return.)
But there’s a well-known exception to the standard relationship. It’s called an “inverted” yield curve, when short-term rates exceed long-term rates. This is not just a rare curiosity. As economists Michael D. Bauer and Thomas M. Mertens of the Federal Reserve Bank of San Francisco point out in a series of papers, an inverted yield curve has proved to be an amazingly reliable predictor of a recession.
An inverted yield curve, they write, “has correctly signaled all nine recessions since 1955 and had only one false positive, in the mid-1960s, when [the inverted yield curve] was followed by an economic slowdown but not an official recession.”
All this is now relevant because interest rates are drifting toward an inverted yield curve. Since the early 1980s, the gap (called “spread”) between three-month Treasurys and 10-year Treasurys has typically varied from one to four percentage points. Now the spread is much less than one percentage point, and if the Fed raises short-term rates, it might narrow further.
Just why inverted yield curves forecast recessions is unclear, Bauer and Mertens write. There are many theories.
Banks and other financial institutions make money by borrowing short at low interest rates and lending long at higher rates. An inverted yield curve frustrates this strategy. Another possibility: By raising short-term rates, the Fed may squeeze current borrowers while dampening long-term inflation. Long-term rates would then decline, because rates reflect expected inflation.
Whatever the causes, the outcomes don’t follow a mechanical formula. Since the mid-1950s, the time spans between inverted yield curves and recessions have varied from six months to two years, report Bauer and Mertens.
The dilemma is plain.
The current job expansion is an important venture in social policy. People who were tossed out of the labor market are returning, along with many who were never in the market. This may have long-term benefits. If the Fed is too aggressive in fighting weak inflation and mild speculation, it might kill the recovery and sacrifice these gains.
On the other hand, the Fed could become too concerned with a recovery. Throughout history, the Fed has been prone to overstay episodes of easy money and loose credit. By the time this is obvious, the damage has already occurred. Inflation has accelerated, or speculation has become widespread. The economy then enters a long stretch of poor performance.
It’s not obvious (to me, at least) which argument is stronger. So, good luck to the FOMC’s members. They will need it.
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