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Affluent Christian Investor | November 17, 2019

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Inverted Yield Curve Doesn’t Cause Recessions, But It Predicts Them

A trader works on the floor of the New York Stock Exchange.
(Photo by Spencer Platt / Getty Images)

One of the big financial news stories of the past month has been the inverted yield curve, which means that the interest rate on long-term government debt is lower than that on short-term debt. During expansions, interest on short-term government debt is lower than long-term. In other words, things are upside down. Inverted yield curves are rare events and often predict a recession within two years, although a couple of recessions have happened without the curve inverting.

John Tamny recently chastised market pundits for claiming that the Fed’s monetary policy is too tight and caused the inverted yield curve. The writers and talking heads who make that claim are followers of a school of macroeconomics known as monetarism. Milton Friedman was a famous monetarist. Monetarists believe that monetary policy drives everything. They have no objective measure of “tight” or “loose” monetary policy. Policy is too tight if the economy is slowing and too loose if inflation gets out of control.

Milton Friedman used the analogy of driving a car. If you travel from the plains to the Rocky Mountains, you won’t be able to keep the same pressure on the gas pedal — pedal pressure being the analogy to Fed monetary policy. The car will slow down as you drive into the mountains, and that’s the sign that you need more pressure on the pedal to give more gas to the engine and maintain a constant speed. Heading down the other side of a mountain the car will gain speed rapidly and the driver will have to reduce the amount of gas going to the engine by taking his foot off the pedal. The goal is a constant rate of car speed near the speed limit for the car and the economy.

Tamny is correct that the Fed didn’t cause the inverted yield curve. Monetarists are simply wrong. They’re guilty of confusing correlation with causation and of giving credit to monetary policy for things the market does on its own. The economists running the Fed are mostly monetarists.

In their defense, the Fed has delivered most of our recessions since World War II by raising interest rates to squelch the inflation they caused from their loose monetary policy. But this time around we haven’t seen much inflation, meaning the massive money creation since 2008 has failed. The Fed has raised its rate six times since the crisis, but in very small increments. The rate is currently around 2.5%. In past expansions the Fed has had to raise rates above 5% to stomp on inflation.

So how could the economy be slowing if, as monetarists claim, Fed policy isn’t too tight? We may be witnessing in this business cycle Hayek’s Ricardo Effect, his business cycle theory. In it, he divides the economy into a capital goods sector and a consumer goods sector. Artificially low interest rates by banks or the Fed causes businesses in the capital goods sector to borrow and invest too much. That puts cash in the hands of consumers who spend it on goods in the consumer sector. But since production of consumer goods hasn’t increased, prices start to rise. Higher prices mean higher profits for producers of consumer goods. Those producers can earn even greater profits by postponing purchases of capital goods, such as equipment, and paying workers to work overtime. Also, they attract workers from the capital goods sectors.

The capital goods producers must now compete with the consumer goods sector for materials and labor so the costs of inputs rise while sales fall as consumer goods producers put off purchases of equipment. Profits disappear in the capital goods sector, followed by layoffs of workers, defaults on loans and bankruptcies. Expansions begin and end in the capital goods sector of the economy. Hayek wrote his book Profits, Interest and Investment in order to show that recessions would happen as a result of rising profits in consumer goods alongside collapsing profits in the capital goods sector whether banks raised interest rates or not.

Part of the reason this expansion is one of the longest in history is the lack of price inflation that would have forced the Fed to raise interest rates earlier. And we have enjoyed low inflation partly because of the many zombie companies that absorb much of the new credit to pay the interest on earlier debt, and partly because of the Fed’s new policy of paying interest on bank reserves. For much of the latest expansion, banks found keeping very large excess reserves a better value for them than making loans to businesses. And banking regulations encourage lending to governments and on real estate while discouraging loans to businesses. Also, much of the new credit went to inflating the stock and bond markets.

The result has been that many businesses borrowed to buy back their stocks rather than borrowing to invest in new or expanding business. The workforce participation rate fell to low levels and consumers had less cash to spend. Some of their earnings they stashed to make up for savings lost in the last recession. All of these factors combined to make the recovery from the recession sluggish for several years, but also to extend it to record lengths.

Tamny is right that market forces flipped the yield curve on its back like a dying beetle. The yield curve may have inverted because capital goods producers have quit demanding long term loans out of fear of falling profits. And falling profits rather than higher interest rates may launch the next recession and accompanying bear market as Hayek’s Ricardo Effect predicted.

 

 

Originally published on Townhall Finance.

 

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