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US economy: the inverted yield curve and recession
Gerard Jackson
Last July Alan Greenspan testified to Congress that the world was probably experiencing a savings glut which was part of the reason why long term rates were falling despite the Fed’s tough interest rate regime. His view was in complete agreement with Ben Bernanke’s. It is now January 2005 and all talk of a global savings glut has been replaced by chatter about an impending recession caused by an inverted yield curve.
But why should long term rates differ from short term rates anyway? After all, doesn’t economics tell us that in the market place there always exists a tendency for the price of identical goods to equalize? The argument that long and short term rates represent different markets will not hold. Economics teaches that where the opportunity for arbitrage emerges goods will be bought where their prices are ‘low’ and sold where their prices are ‘high’ until a uniform price (ignoring transport costs) is established.
It therefore follows that in the case of interest rates the yield curve should be flat. Should any variations create an opportunity to make profits they will be quickly competed away. If, for example, a positive short term curve should appear the response of market participants would be to abandon short term rates in favour of long term rates, and so quickly drive up the former while simultaneously driving down the latter.
So how is it that financial markets can allow short term curves to persist for long periods of time? The answer, as always, is the central bank. By continually injecting funds into the market it creates a positive curve by driving short term rates down. Naturally this means that in order to maintain the curve it must continually make monetary injects.
However, there comes a time when the economic consequences of this inflationary policy forces the bank to start tightening the money supply until an inverted curve emerges. If we look at the Fed’s monetary figures we see that from January-December 2004 M1 rose by about 7.7 per cent. But from January-December 2005 M1 rose by only 2.5 per cent. I believe that this marked slowdown in monetary growth explains what is happening to the yield curve.
Eventually the tightening brings about a downturn and the malinvestments generated by the monetary expansion emerge in the form of idle capacity and rising unemployment. It’s impossible to say when this will happen to the US economy, even when looking at the monetary aggregates.
The situation reminds me of the inter-central bank conference at New York, in July 1927 Benjamin Strong told Charles Rist, Deputy Governor of the Bank of France, that he was going to give “a little coup de whiskey to the stock market,” meaning he was going to give it another monetary shot in the arm.
My point being that there is no telling how the Fed will respond to an imminent slowdown. If it were to reverse its tightening and accelerate monetary growth that could delay the recession (necessary adjustment period) for quite awhile. How long that would be, however, is impossible to say.
I can only repeat what I have said before: Greenspan’s loose monetary policy laid the foundations for another recession.
Gerard Jackson is Brookes’ economics editor
BrookesNews.Com
Monday 30 January 2006