Beware the Slippery Slope

Each of the eight recessions since 1950 has been preceded by a flat or inverted yield curve.

By Jeremy J. Siegel, Contributing Editor

From Kiplinger's Personal Finance magazine, August 2005

It's important for a good bond trader to watch the central bank. But it's equally important for the central bank to watch bond traders. The conundrum of falling long-term interest rates paired with rising short-term rates, which Federal Reserve Board chairman Alan Greenspan spoke about so forcefully last February, is back with a vengeance. Not only has the yield on ten-year government bonds fallen to 4%, but rates of long-term bonds are also tumbling all over the world. History indicates that it could be very bad for the Fed to continue to raise short-term rates in the face of declining long-term rates.

Portents

The warning signs are found in the shape of the yield curve. Picture a chart on which the years to maturity are plotted across the bottom and the interest rate is plotted vertically. Normally, the line showing the interest rate curves upward as you go out in years, because lenders demand a premium to lend their money long term at a fixed rate.

But when long-term lenders see an economic slump on the horizon and anticipate that interest rates will fall sharply, they become willing to lock up their money at lower rates -- sometimes at rates even lower than short-term rates. In this rare situation, an inversion of the yield curve occurs as the chart's interest-rate line slopes downward.

A downward-sloping yield curve usually means trouble ahead. Each of the eight recessions since 1950 has been preceded by a flat or inverted yield curve. Only once, in 1966, did the yield curve invert without a subsequent recession. But the government ratcheted up spending on the Vietnam war and rescued the economy from an impending slump.

Right now the yield curve is flatter than it has been at any time since the last recession, in 2001. That should caution the Fed about continuing to raise short-term rates in the face of declining long-term rates.

Although the Fed is well aware of the significance of yield-curve inversions, its Open Market Committee has its eye on another monetary indicator that is not yet flashing red: the real, or after-inflation, interest rate that the Fed sets in the federal funds market for bank reserves. Over the past 50 years, the federal funds rate has averaged about two percentage points above the rate of inflation, producing a rate that the Fed says is consistent with a neutral monetary policy. Pursuing a neutral monetary policy means setting interest rates so that they neither stimulate nor restrict economic activity.

Ever since the recession in 2001, the Fed has been following an appropriate policy to stimulate the economy, driving the real fed funds rate well below 2% and even below zero. But with the economic recovery, the situation has changed. Given that core inflation is now running between 2% and 3%, the Fed has to raise the funds rate to at least 4% to achieve a neutral policy.

But a real fed funds rate of 2% may not be the right number today. Long-term real interest rates are already well below 2%. Given that short-term rates should be below long-term rates, it can be argued convincingly that a neutral monetary policy today is now reached at a much lower real rate than in the past, perhaps 1% or even lower.

Rethinking policy

In that case, the Fed is near neutrality now and any further increase might harm the economy. As we went to press, it was all but certain that the Fed, which began raising rates a year ago, would increase the funds rate to 3.25% in late June. Then the central bank should pause. If commodity and oil prices soar to their old highs again, the Fed will have to continue raising the funds rate -- it's that or risk letting inflation spiral out of control. But if core inflation stays low, a reevaluation is in order. We don't want the Fed heading down the slippery slope to a recession.

Jeremy J. Siegel is a professor at the University of Pennsylvania's Wharton School and author of Stocks for the Long Run.

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