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American monetary policy and its less curvy yield curve

Bhuwan Thapaliya - 1/29/2007

The United States of America is the world’s largest and most successful economy with a Gross Domestic Product(GDP) for 2006 of $13.3 trillion dollars but according to some analysts, this giant economy is about to collapse into a recession. Is the American economy about to collapse into a recession or is it just an expert’s speculation?

This is one of the most important questions that modern economists might be expected to answer, but it is not one they find very easy given the diversity of the American economy. Nonetheless, experts view cannot be ignored totally because the dollar is continuing to fall and it should be noted here that today the value of the dollar is 5% of its value at the beginning of the twentieth century, according to the sources.

For the thirteenth time in last 18 months, America’s Federal Reserve increased interest rates and in the process quadrupling it from 1% to 4.25%. The question now, however, is whether it will prove to be the last. The answer is almost certainly no. America’s economy is still growing, and without a firmer stamp on the brakes, inflation will soon start to accelerate. Real GDP increased at an annual rate of 2.0 percent in 3rd quarter 2006, making 3.4% (average Q1-Q3) for the year 2006.

It is true that inflation still remains modest but if growth continues to outpace the economy’s long -term productive potential, which depends upon the growth in productivity and of the labor force, labor shortages and capacity constraints, will eventually push up inflation, according to some analysts.

Moreover, most economists are predicting a slow down in growth this year. The question is whether it will come early enough to prevent overheating, and so relieve the Fed of the need to raise interest rates more aggressively. Almost most economists are still forecasting a soft landing, a small but growing number now expect the economy to remain robust in early 2007; the eventual slowdown will therefore be much sharper.

The latter group of economists has become mesmerized by the shape of yield curve- the graph that plots yields on securities of different maturities. In the past, the shape of curve (more precisely, the gap in yields between long and short term bonds) has proved to be good leading indicator of economic activity.
Why should this be? In normal times, investors demand higher yield curves or longer dates bonds to compensate them for the greater risk, but the required premium varies according to their expectations of growth, inflation and thus the future path of interest rates.

For example, the yield curve sloped steeply upward in 1992-93, reflecting the markets expectations that future growth - and hence inflation and short term interest rates- would increase. Investors therefore demanded a bigger premium on securities with a long maturity.

By contrast, when the Fed lifts short tem interest rates in order to dampen growth, the gap between long and short term bond yields usually narrows in a pincer movement. While yields on shorter term bonds are pulled up by rising short term interest rates, those on long - term bonds fall as inflationary expectations ease.

Meanwhile, if the Fed continues to tighten policy, short term rates eventually rise above long term rates and the yield curve become "inverted". Because investors expect weaker growth in future, and hence lower interest rates, they will accept lower rates on long - term bonds.

As a forecasting tool, the yield curve has impressive credentials: it has become inverted 12-18 months before every recession during the past 50 years, and only once over that period has there been a false alarm, when an inversion of the curve was not followed by a recession.

That was in 1965-66, when heavy government spending during the Vietnam War helped to avert a full recession, and growth merely slowed.

What is the curve signaling now? The yield curve is negative now. One year ago, the graph of yields was nicely curvaceous but now the, yield curve is getting quite flat , and analyst say the yield curve is about to be inverted- an unusual state of affairs, which tends to be a clear warning sign of impending recession.

But economists say there is nothing much to worry about because in unique circumstances for short periods of time only, the yield curve inverts and given the diversity of the American economy and its capability to bounce back in any situation, when this happens, automatically the yield curve will revert to its normal upward- sloping shape.

But Federal Reserve economists are not taking anything for granted. They are serious about the slope of the yield curve. Their study suggests that the chances of a recession occurring within 12 months are high, a truly worrying number not only for America but for the world economy too.

Nonetheless, analysts say, cautious we must be, but not fearful because the yield curve rarely inverts. The reasons why the yield curve rarely inverts are simple: there is always price inflation in the United States, and price inflation is still a threat to the U.S. economy this year because of the rising energy prices and the falling dollar.

The dollar is out of line, because of the need to finance America’s hefty current account deficit. And the problem for those who want a stronger dollar is that the value of dollar is not set by politicians but by markets on the basis of the relative performance of the economics.

Nonetheless, somewhere behind all the squabbles lies a debate over whether the American economy is heading for recession or inflation. Statistical evidences suggest that it is heading towards inflation, and the current recipes are of inflation and not of recession, expert argues.

Without a doubt, the conventional wisdom suggests that an inversion of the yield curve is improbable because inflationary pressures are not that alarming and because the Fed started to tighten policy early in the economic cycle, interest rate need not rise much further.

This argument might be more convincing were it not for the fact that in 1988 many economists similarly argues that the yield curve, which was then also flat, would not invert. In 1989 it did and recession set in 1990.

Nonetheless, no expert can deny that the dark clouds are looming over American economy, and the forecast is not shady at the moment, but by no means it is bright. Considering this status quo, the Fed must act soon. What it should do? The Fed must play a tough game: it must weigh up future inflationary risks against the danger of pushing the economy into recession.

But the dilemma for Fed, however, is this. The hitch is that monetary policy is not a science: there are long lags of around 18 months before changes in interest rates affect economic activity, and the extent of their impact is unclear.
Ben Bernanke, the Fed’s chairman, as if by a magic wand cannot bring the rate of growth exactly in line with the economy’s productive potential. The best he can do to avoid a recession is to prevent serious overheating.

Whatever, most importantly for America, the current Chairman of the Federal Reserve, Ben Bernanke, an anti- recession connoisseur would by no means allow the U.S economy to fall into a recession.

Like the recently deceased economist Milton Freidman, Bernanke too hates recession, and he has every reason of hating it because now U.S is trying to find equilibrium, not just in its economy, but in its entire society. American cannot afford recession and let us hope that it will not have to bear that unnecessary burden.