If Fed tests the patience
When the Federal Reserve backed off its December projection for additional rate increases in 2019 and opted instead for patience, there was a collective sigh of relief from financial markets. Now that patience is being tested.
Not in the way the Fed originally intended, which was patience in the process of raising its benchmark rate, at least until the data were more persuasive. Pressure is now growing from financial markets for a relief in the opposite direction, and the Fed should oblige by lowering rates.
Friday’s stock market selloff sent the yield on the 10-year Treasury note tumbling to a 14-month low of 2.42%. The spread between the 3-month Treasury bill, a proxy for the Fed’s policy rate, and 10-year Treasury note inverted ever so slightly: the first negative reading since 2007, just as the Fed was, belatedly, about to start lowering rates.
The predictive power of an inverted term spread or yield curve when it comes to recession has been widely recognized in recent years, even as it is widely dismissed when it occurs, at least in prior business cycles. The New York Fed devotes an entire section of its website to “the yield curve as a leading indicator,” complete with a recession probability model.
San Francisco Fed economists Michael D. Bauer and Thomas M. Mertens have conducted extensive research on the term spread, concluding that it is “one of the most reliable predictors of future economic activity.”
They determined that the 3-month/10-year spread performs better than other spreads, including the 1-year/10-year spread and those that adjust for the term premium, or the extra compensation investors demand for holding a longer-term security. They also found that the predictive power of the term spread was unaffected by variables such as the historically low natural rate and low or negative term premium.
Inversions need to endure for more than a few days if they are to have predictive power. If the current inversion persists and deepens — if long-term rates continue to decline, widening the gap with the Fed-driven 3-month bill — the Fed should lower its policy rate. And quickly.
That shouldn’t be a problem for the Powell Fed, which has already shown itself to be much more nimble than its predecessors. For an institution that prides itself on consensus-building and prefers to move in slow, incremental steps, the Fed’s about-face on the policy outlook in recent months has been nothing short of breath-taking.
In early January, Powell walked back his December assertion that the balance sheet runoff was on “autopilot,” only to announce last week that it would officially conclude by the end of September.
The same “flexibility” is evident in the Federal Open Market Committee’s projections for the funds rate. In September, the median FOMC forecast for the benchmark rate at the end of 2019 was 3.1%, implying three additional rate hikes. By December, it was down to two, moving to zero at last week’s meeting.
None of these forecasts coincided with any major change in the outlook for the U.S. economy, even amid a global slowdown.
Given the central bank’s responsiveness to financial conditions, there’s a decent chance that the Powell Fed, unlike its predecessors, will act before it’s too late, responding to any extended inversion with a rate cut.
And it’s better to be pre-emptive: take out some insurance against recession. (This is the antithesis of the lame idea that the Fed should have raised rates when the economy was struggling to “make room” to lower them later.)
The funds rate at 2.25%-2.50% is not far from the zero lower bound, depriving the Fed of the necessary interest-rate medicine in the face of a downturn. (The average decline in the funds rate during recessions has been 5 percentage points, according to Harvard University economist Larry Summers.)
Inflation has remained stubbornly below the Fed’s 2% target for the better part of the expansion, which turns 10 years old in June. That gives the Fed little room to generate negative real rates in the face of a recession.
A persistent inversion will serve as a test of policy makers’ convictions: Will they convert words — acknowledgment of the spread’s predictive power — into action?
The early signs were not encouraging. This week, Philadelphia Fed President Patrick Harker and Chicago Fed President Charles Evans speculated about the prospect for future rate increases.
Still, I doubt the Fed will stand idly by in the face of a significant yield-curve inversion. The fed funds futures market is putting the probability of one or more rate cuts by year-end at 68%. The odds of a rate hike are zero.
Patience may have been a virtue for the Fed over the last few months. Going forward, exercising patience may be contraindicated.