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The yield curve inverted

Summary:
The Financial Times reports that the yield curve inverted, albeit by just 1 basis point: Uh ohDoes this mean a recession is more likely than before? Yes. Does this mean that a recession is likely in the next 12 months? Probably not. Does this mean that monetary policy is too tight? Hard to say. In my view, the current situation reminds me most closely of 1998, when the US economy was pretty strong at a time when the global economy was weakening. That year also saw a mild inversion, which turned out to be an incorrect recession forecast: Ah, more reassuringIn its entire history, the US has never experienced a soft landing, in the sense of having a recovery extend for many years after unemployment had fallen close to the natural rate. Since

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The Financial Times reports that the yield curve inverted, albeit by just 1 basis point:

The yield curve inverted
Uh oh

Does this mean a recession is more likely than before?

Yes.

Does this mean that a recession is likely in the next 12 months?

Probably not.

Does this mean that monetary policy is too tight?

Hard to say.

In my view, the current situation reminds me most closely of 1998, when the US economy was pretty strong at a time when the global economy was weakening. That year also saw a mild inversion, which turned out to be an incorrect recession forecast:

The yield curve inverted
Ah, more reassuring

In its entire history, the US has never experienced a soft landing, in the sense of having a recovery extend for many years after unemployment had fallen close to the natural rate. Since unemployment has fallen close to the natural rate, that fact alone should make us worried. On the other hand:

1.Australia and the UK have experienced soft landings in recent decades.

2. In previous US expansions, you didn’t have MMs beating the drum for stable NGDP growth, level targeting. (Yes, I’m joking.)

When unemployment falls to the natural rate, problems are almost always just around the corner. In 1966, the yield curve inverted when unemployment fell below 4%, and again there was no recession. But there was a problem just around the corner—high inflation.

So low unemployment is a very dangerous time for the US. We are a clumsy country, which fails to achieve soft landings. That’s the real story here, which is even deeper that the “inverted yield curve means recession” story. Low unemployment and inverted yield curves are a warning of choppy waters ahead, of monetary policy in danger of drifting off course, one way or another.

In my view, the stock market decline at the end of 2018 was partly due to a perception that rates should not be increased, while the Fed was planning another set of rate increases in 2019. (Other worries such as trade, global growth, etc., also played a role).

When the Fed backed off, stocks rallied. Despite today’s sell-off, stocks are at very lofty levels and hence stock market investors likely don’t foresee a recession during the next 12 months. Neither do I. But it would be foolish to deny that the recent yield curve inversion makes a recession more likely than before, say a 25% risk rather than a 15% risk.

Update: This recent post had more to say on the yield curve issue.


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Scott Sumner
Scott B. Sumner is Research Fellow at the Independent Institute, the Director of the Program on Monetary Policy at the Mercatus Center at George Mason University and an economist who teaches at Bentley University in Waltham, Massachusetts. His economics blog, The Money Illusion, popularized the idea of nominal GDP targeting, which says that the Fed should target nominal GDP—i.e., real GDP growth plus the rate of inflation—to better "induce the correct level of business investment".

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