Greg Ip

Articles by The Economist’s U.S. Economics Editor

For now, trust the yield curve

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Jul 7th 2010, 20:58 by G.I. | WASHINGTON, DC

[Greg Ip] IF YOU’RE making a call on a double-dip recession, you must also make a call on the credibility of the yield curve. An inverted curve (with the ten-year Treasury yield falling below the three-month T-bill rate) has preceded each of America’s last seven recessions. It has had two false positives, in 1966 and 1998, the Cleveland Fed notes. The lead time varies from a few months to two years. It is currently relatively steeply upward sloping.

Is this time different? By definition, when short-term rates are at zero as they are now, the yield curve can’t invert, yet it would be ridiculous to say that means we can’t have a recession. A correspondent points out that Japan’s yield curve was positively sloped throughout the 1990s but Japan still had recessions.

With that caveat in mind, for now I’m going to trust the yield curve, for two reasons. First, people have said “this time is different” before to discount the yield curve’s value as a leading indicator. In 2006-2007 some scholars argued an inversion that occurs when nominal short-term rates are low is less meaningful than when monetary policy is clearly restrictive. The lesson: think twice before explaining away the yield curve with special factors.

The second reason is that the yield curve owes its forecasting power to the powerful influence interest rates have on the business cycle. It’s obvious that when the Fed jacks short-term rates up dramatically, that can, and does, slow the economy down. Less obvious, even when the tightening is relatively modest, as in 2007, is that when short-term rates rise above long-term rates it is a powerful retardant to credit creation. Our entire financial system relies on borrowing short and lending long and profiting from the spread. When that spread disappears, sooner or later, so does liquidity. In 2007, that happened in dramatic fashion, partly because we didn’t realise how precarious liquidity was in the vast shadow banking system. Indeed, the more I study the events of the last few years, the more I’m convinced that illiquidity contributed more to the crisis than insolvency.

What all this tells me is that as long as the yield curve remains relatively steep, it is a powerful inducement to credit creation. Credit is currently contracting, but with time the positive lending spread will recapitalise banks and awaken interest in lending. Right now is an excellent time to start a bank: just check out the enthusiasm among private equity funds for buying failed banks from the FDIC.

I’m not ruling out a double dip. But in assessing its odds, you have to start by acknowledging that double-dips are rare: there aren’t any in the post-war experience of the United States with the exception of 1980 and then 1981-82, and both those dips were deliberately induced by the Fed and preceded by an inverted yield curve.

Why might this time to be different? There’s the risk of fiscal contraction. Arithmetically you could get a negative quarter or two of economic growth from the expiration of Barack Obama’s stimulus and George Bush’s tax cuts. Would that initiate a new, self-reinforcing downward cycle in activity, or just a transitory dip? The latter would be a double-dip recession in name, but not in spirit.

That brings us back to the Fed. It owes its influence over the business cycle to its powerful lever over liquidity. This lever has, in the post-war period, usually operated through the short-term interest rate, but that is not its only channel. Everyone blames the infamous 1937 depression-within-a-depression on premature fiscal austerity, but perhaps more important was the Fed’s mistaken move to raise reserve requirements. Similarly, this year’s European debt crisis was precipitated by the European Central Bank moving to end unlimited lending to banks against peripheral sovereign bond collateral (killing what had been a lucrative spread trade for European banks). It is thus conceivable that the Fed could, perhaps inadvertently, do some damage by a regulatory or policy change that saps liquidity again. I can’t think what that might be, but it’s a danger worth keeping in mind.

The original post is here.


Written by gregip

July 7, 2010 at 3:38 pm

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