One myth upheld even by many people who has a basically sound outlook on monetary issues is the view that an inverted yield curve (where short term interest rates are higher than long term interest rates) will cause a recession. It is a well known fact that the yield curve tends to invert just before recession, so therefore many people have concluded that the inversion of the yield curve is a causal factor behind the recession.
The implication of this is that the sharp increase in long-term bond yields (up more than 50 basis points) the last 2½ months is actually bullish for the economy!But why would it cause a recession? Well, because supposedly banks raise funds whose cost is determined by short-term interest rates while the interest rates of their lending is determined by long-term yields. And so, if the yield curve inverts, banks will find it unprofitable to lend, ending credit expansion.
In reality, this picture is for the most part misleading. Most lending to households are in mortgage debt, which is usually financed by the issuing of bonds with the same maturity as the mortgage (In adjustable rate mortgages, it is in short-term debt, but then the interest income for the bank will rise too if short term rates rise) Moreover, banks do not always raise deposit rates by as much as the central bank rate and often they lend with adjustable rates. All of which make the causal recessionary link very weak, at best. And whatever link there is, is likely to be more than overwhelmed by the negative effects that rising long-term interest rates have on mortgage lending, stock prices and other parts of the economy. This makes a rise in long term rates bearish for the economy even if it makes the yield curve slope more positive.
So, if it is not a causal factor, why are recessions usually preceded by an inverted yield curve? This is simply because long term yields are fundamentally determined by future short term interest rates. Otherwise, people could make large arbitrage profits by borrowing with short term interest rates and lending in long term interest rates (or vice versa). And as short term interest rates are at their highest during the cyclical peak, they will be above the cyclical average during those peaks, which in turn means that short term interest rates will be above long term interest rates at those points. However, this assumes that the markets will successfully predict the cyclical peak in interest rates. If they think they have peaked, but inflation and the economy for some reason unexpectedly accelerates, then a recession will not follow an inverted yield curve.
The case of Australia is particularly interesting in this context. The yield curve has been inverted almost all of the time since late 2004. Yet as I reported yesterday, Australia’s economy has not only not slipped into a recession, but is enjoying very strong growth. Of course, this is again mainly a result of the sharp increase in demand for Australian commodities from China. But this is not just a case of a third factor (the commodity boom) preventing the outbreak of a recession. The inverted yield curve is in fact combined with double digit monetary growth, illustrating that an inverted yield curve need not be associated with tight monetary conditions.
In short: an inverted yield curve tends to be associated with recessions because they reflect market expectations of an imminent peak and reversal of central bank interest rate increases. But they are not a causal factor behind recessions (at least not to the extent they reflect lower long term yields) and so rising long term yields are not bullish for the economy.
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It’s the second time recently that(as Prof. Shostak also wrote) I read that the monetary policy in Australia is that much inflationist DESPITE relatively hight short term interest rates…
So what are the governmental means involved here in making more liquidity?
Might not the argument be that short term rates are RELATIVELY low in these cases, compared to some assumed rate that “should” be in place?
If this were the approach taken, there is an obvious problem, in that any proposed rate may reduce to a matter of individual value judgments.
That’s why it may be logically more consistent to conceive that it isn’t the rate per se that is the fundamental problem. Rather it is that credit is monopolized.
Any monopolized rate then, can be assumed to be too high or too low, from the point of view of individual value judgments. Because individuals are not free to choose their own currency and credit arrangements (quality of currency and credit, and price of currency and credit), according to their own value judgments.
And that ties in to some libertarian’s claim that multiple sources of currency and credit should be allowed to freely compete. (free banking, etc.)
AK
Australia has relatively high interest rates compared to most other advanced economies, but this only reflects that demand for credit is so strong for various reasons. Interest rates are still below where it would have been had there not been any monetary inflation.
Hi Stefan.
Artisan’s question was essentially that in claiming Australia’s policy is inflationist (if that is the claim), doesn’t this imply a statement about the purposeful activity of their government, central bank, or some Australian agency?
His question was, what MEANS are they using to create inflation? (his term, liquidity)
Adam
I think the yield curve is important to look at (just like the spread over junk bonds is important), but it’s by no means the end all be all and certainly doesn’t cause a recession when it inverts.
However, changes in a monetary statistic are important. I’ve found the most useful is the monetary base adjusted for CPI (but Shostak’s AMS or Shedlock’s Mprime are also useful). If the change from a year and a half ago to today is negative, it significantly adds to the probability of a recession. But even that isn’t the most important thing, the federal funds rate (or the equivalent in Australia) and the yield curve should also be included in even the most basic analysis.
I think the important thing to stress is that when you look at the right monetary indicator, it’s easy to find that money does matter. Interest rates matter too as well and many other variables matter too, but money and interest rates should be front and center in assessing the state of a developed economy.
OK, let’s put it this way: inflation is driven by the high credit needs of Australia which would NORMALLY call for even higher interest rates… and the politics is too much accommodating… so even if the government doesn’t produce inflation on purpose, I’m curious to know what factors cause Australia’s credit policy to create so much more inflation(M3) than the US interest rates for instance?
I have never heard anyone claim and inverted yield curve causes a reccesion. a reverted yield curve is simply a speculated future interest. However, since the wisdom of the crowds demonstrates that people are quite good at predicting the future when there opinions are combined – we might expect that speculated interest rates are fairly accurate. Granted this is true, an inverted interest rate curve implies that future interest rates will be lowered, and this usually occurs during a reccesion.
Grey Swan
Also I have never heard that inversion of yield curve causes recession; it’s just that market rates in the future are expected to decline. Then it it’s just an indicator of future recession.
Stefan, Austrian economist Friedrich Lutz wrote article about this in 1940 which was published in QJE (“The Structure of interest rates”).
If interest rates are the sum of the marginal capital gains and the inflation rate, the inverted yield curve can predict less capital gains or lower inflation in future or both.
Seems to me that somebodys got the cause and effect reversed. Surely when inflation is being felt (after the issue of too much credit or possibly by the older fashioned printing of more money), then the rate of interest must increase in order to make it worthwhile for savers to continue to save rather than withdraw and spend?
Thus the rate of interst follows and does not cause the inflation to develop.
USA goes into recession, well, the world economy is dependent on us. We’re the heartbeat, aren’t we? I’ve seen it in the comments a few times that this will slow down demand quite a good little bit. Is this true?.
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smithsan
Business Sales
In hindsight it looks like the inverted yield curve in Australia and other countries such as the U.S. was a sign of an upcoming recession or contraction … but I would not say it was the cause.
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