Economic recovery and the yield curve

Gerard Jackson
BrookesNews.Com
Thursday 14 2003

I have given tentative support to the view that the US economy is building up steam. This support was not based on interest rate movements but on the fact that productivity surges and pickups in manufacturing are usually strong indicators that economic recovery is underway.

Although economic commentators have drawn attention to the rapid increase in productivity most have them appear to be more influenced by interest rate movements.

For more than 50 years economic recovery has been preceded by a positive yield curve: that is to say that long term rates have exceeded short term rates, which is the current situation. This observation has led market analysts to usually base their predictions of recession and recovery on the difference in long and short term rates, very much to the exclusion of everything else.

However, some commentators have changed tack, arguing that the rise in long term rates will undo any recovery. They reason that the rise either indicates future inflationary problems or is the product of a growing deficit that will blunt recovery. Some go so far as to combine the two, concluding that recovery is either impossible or will be short-lived.

I'm prepared to admit that there may very well be an inflationary premium in current long-term rates. I might also agree that the deficit may also have contributed somewhat, though this cannot be proved. What I would not agree to is that these factors actually caused the interest rate differences!

It has always been axiomatic in economics that in a free market there exists a tendency to equalize the prices of the same good. From this we conclude that interest rates are no different. If we take interest as the price of time it will follow that aggregated time preference scales will tend to equalize interest rates.

Therefore the yield curve would tend to be flat, with long and short-rates being equalized, regardless of, for instance, the anticipated rate of inflation.

Unfortunately badly hampered markets are the order of the day, and time markets are not exempted. The yield curve is positive because the Fed's loose monetary policy has artificially depressed short-term rates. In the absence of this kind of monetary misbehaviour rates would tend to be uniform.

This policy of interest rate manipulation will eventually bring about a negative yield curve as the Fed once again applies the monetary brakes. It is this 'monetary cycle' that causes booms and busts, nothing else.

To argue that recessions are inherent in free market economies is to mistake the symptoms for the cause.

Gerard Jackson is Brookes' Economics Editor