Should the Fed Fear the Yield Curve?

Last week, the Federal Reserve increased interest rates, and promised much more of the same in the months ahead. The consensus among the Federal Open Market Committee (FOMC) sees overnight interest rates peaking at close to 3% before settling back down.

Tightening of this scale may be necessary to bring inflation to heel. But it may also raise the risk of recession. The Fed would certainly like to avoid this outcome, but may view the long-term economic costs of high inflation to be larger than the cost of a short downturn.

Yield curves have a muddy relationship with recessions.

As each step in the tightening process is considered, these risks will be reassessed. One gauge that will certainly be consulted is the yield curve, which is thought by many observers to be a primary recession indicator. The yield on two-year Treasury securities has exceeded the yield on ten-year Treasury securities prior to each of the last four U.S. downturns.

Yield Curve - Chart 1

The intuition behind this juxtaposition is that central banks will have to retreat at some point in the future, which typically occurs when growth is faltering. To be clear, though, there is no cause-and-effect.

A closer look at the history raises some questions about the signal given off by the yield curve. There have been inversions which corrected without being associated with a downturn. The lead time between an inversion and a recession is highly variable; it has been as short as three months and as long as 20 months.