What Will The Fed Do If The Yield Curve Inverts? Goldman Answers

Right, so the yield curve has been the talk of the financial universe for months now because, well, because it’s collapsing and by many accounts has a date with inversion. Historically speaking, that’s a bright red flashing light vis-a-vis the economy.

The December Fed minutes suggest everyone spent a fair amount of time debating exactly what the fuck is going on and whether it’s something anyone needs to be particularly concerned about. Here’s the relevant excerpt:

Meeting participants also discussed the recent narrowing of the gap between the yields on long- and short-maturity nominal Treasury securities, which had resulted in a flatter profile of the term structure of interest rates. Among the factors contributing to the flattening, participants pointed to recent increases in the target range for the federal funds rate, reductions in investors’ estimates of the longer-run neutral real interest rate, lower longer-term inflation expectations, and lower term premiums. They generally agreed that the current degree of flatness of the yield curve was not unusual by historical standards. However, several participants thought that it would be important to continue to monitor the slope of the yield curve. Some expressed concern that a possible future inversion of the yield curve, with short-term yields rising above those on longer-term Treasury securities, could portend an economic slowdown, noting that inversions have preceded recessions over the past several decades, or that a protracted yield curve inversion could adversely affect the financial condition of banks and other financial institutions and pose risks to financial stability. A couple of other participants viewed the flattening of the yield curve as an expected consequence of increases in the Committee’s target range for the federal funds rate, and judged that a yield curve inversion under such circumstances would not necessarily foreshadow or cause an economic downturn. It was also noted that contacts in the financial sector generally did not express concern about the recent flattening of the term structure.

Whatever, right? Obviously they’re going to put their least alarmist foot forward there, but it’s worth noting that “crazy eyez” Kashkari cited the curve as one reason for his dissent in December.

“Continuing to raise rates in the absence of increasing inflation could needlessly hold down wage growth while potentially increasing the chance of a recession,” Kashkari said last month in a statement explaining his third dissent of the year. “While the yield curve has not yet inverted, the bond market is telling us that the odds of a recession are increasing.”

Naturally, this raises questions about whether an inversion would prompt the Fed to slam on the brakes when it comes to the hikes. For their part, Goldman says the answer is no. Or at least probably not.

“We expect the curve to flatten further in the years ahead, though we do not expect it to invert,” the bank wrote, in a note dated Friday. “Even so, the scenario is plausible enough that it is worth considering how the Fed might react.”

Yes, that’s “worth considering,” and when they “considered” it, Goldman came to the conclusion that as long as the econ holds up, the Fed would not be deterred for three reasons (note: there’s more than a little irony in the first reason).

Via Goldman

First, if an inversion arose largely because the back end of the curve were depressed by very low or negative term premia, say due to factors such as foreign spillovers from global QE, many Fed officials would see this as something to lean against rather than as a signal of recession risk. Chairs Greenspan, Bernanke, and Yellen have all cautioned that the decline in the term premium (Exhibit 3) means that the bar for inversion is much lower today, and an inversion therefore no longer signals that current interest rates are nearly as far above expected average future short rates as in the past. If depressed term premia are simply another manifestation of too-accommodative financial conditions, as President Mester suggested, it would be natural to lean against them through a higher policy rate.

Second, even if an inversion arose with a zero or positive term premium, indicating that the policy rate exceeded expected average future short rates and perhaps also the market-implied neutral rate,  this need not seem inappropriate, much less alarming. An at least modestly contractionary policy stance could be a quite mundane response to something like the combination of near-target inflation and historically low unemployment rates that we expect in coming years.

Third, President Dudley’s comment suggests that many Fed officials probably do not think that an inversion causes (rather than signals) higher recession risk. Many might instead think that at least in some cases the opposite is true: an inversion–even a more material one–due to tightening aimed at containing overheating would actually reduce recession risk.

Ultimately, Goldman reminds you that this is largely an academic exercise because according to them, the curve isn’t likely to invert in the years ahead.

Draw your own conclusions.