Contribution Is there a way out of recession fears?

How the Fed can manage to avoid recession after rate hikes and yield curve inversion

By Stephen Lee

Stephen Lee is the chief economist at Meritz Securities, Seoul. Courtesy of Meritz Securities

It hasn't been long since we experienced a recession. The U.S. experienced a two-month long recession ― the shortest and deepest ever ― during March and April 2020, and has been on an expansion trend ever since. A massive amount of fiscal stimulus contributed to helping the economy get out of recession in just two months. But this stimulus, combined with global supply chain problems during the recovery, also pushed consumer price inflation numbers to a 40-year high of 8 percent.

The start of U.S. Federal Reserve Chair Jerome Powell's second term in November 2021 gave birth to the Fed's “pivot-to-inflation” strategy. Since then, inflation numbers have been drifting higher and the Fed's monetary policy stance has turned more hawkish by the month.

The Fed made its first liftoff in March 2022 and issued its new revised economic projections the same day. The Fed's dot-plot ― a compilation of individual FOMC officials' projections for the optimal Federal Funds Rate (FFR), the central bank's key short-term interest rate ― showed that most of them projected the FFR to be above its longer-run level (2.4 percent) by the end of 2023. The longer-run level is often perceived as the neutral level of policy rate ― a level that does not boost nor tighten the economy. Thus, a policy rate above the neutral level means a de facto monetary “tightening,” causing an economic downturn and often a recession.

Keep in mind that this scenario is what the FOMC members consider to be “optimal.” The ideal and the practice differ, as both the chair and vice chair nominee Lael Brainard commented that the rate would first go to neutral by this year, and then the Fed would decide whether to go beyond that next year. We will be seeing multiple hikes this year, including some big steps (hikes of possibly 50 basis points, with a basis point being 1/100th of one percentage point) possibly in May and June. This situation is no longer a surprise, as the expectations are mostly priced into market yields.

Nonetheless, what if the Fed decides to push rates above neutral? Would doing so imply that they are wrecking the economy, causing a recession? Historically, the Fed went too far in many cases, but there are also episodes when the Fed avoided recession after a series of rate hikes. These cases were in 1967, 1984 and 1995 ― which Chair Powell referred to when he made a speech at the National Association for Business Economics (NABE) Conference.

How did the Fed manage to avoid recession during those years? The common feature was the Fed's nimble response to economic downturns. The leading indicators slowed along with inflation pressures waning. The Fed conducted rate cuts less than six months after their rate hikes. In the years, 1984 and 1995, rate cuts were made after the Fed pushed the FFR above neutral. The rate cut in 1967 enabled the U.S. economy to avoid a recession thanks to inflation slowing. But the Fed had to come up with a series of aggressive rate hikes in 1969 despite the economic downturn because inflation pressures were mounting. The economy then ran into a recession in 1969-1970.

The cases of 1967 and 1969 provide lessons for today. If consecutive rate hikes and the relief of supply bottlenecks are combined and eventually push the inflation rate down, the Fed may not have to bear the risk of driving the economy into another recession. Whether the Fed's flexibility pays off or not will likely be determined next year, after the FFR approaches neutral.

Is this time's yield curve inversion different?

Other fears of a recession are being caused by the recent yield curve inversion ― a phenomenon in which short-term bond yield rises above that of the longer-maturity bond yield. This phenomenon is unusual because longer-term yields deserve premiums because they involve giving up today's cash for a longer period. During the first four days of April 2022, the two-year Treasury bond yield rose above that of the ten-year Treasury bond yield.

A yield curve inversion is often perceived as leading to a recession. The longer-term (ten-year bond) yield is a function of the economic cycle, growth and policies. The shorter-term (two-year bonds and below) yield usually relies on monetary policy. A yield curve inversion implies that the monetary policy is too tight for the economy to endure, and it has been the case that such situations have preceded recessions in economic history.

Despite its characteristics, many have argued that the yield curve inversion may not be a viable indicator of a coming recession. In 2006, the global savings glut was one reason proposed but was then proven wrong when the global financial crisis occurred. Yield distortion due to the Fed's Large Scale Asset Purchases (LSAP, also known as “quantitative easing”) is another reason being suggested as a supporting argument for this time being different. On the other hand, there are people like Larry Summers (the former U.S. Treasury Secretary) and William Dudley (the former president of the New York Fed) who nevertheless argue that the Fed is too late and recession is inevitable. Who is right?

I would like to suggest three criteria to judge whether the yield curve inversion suggests imminent recession in the future. First, post-1980 episodes show that the yield curve (with a two- to 10-year yield spread) stayed inverted for more than four months consecutively before recessions. We saw yield curve inversions during 1998 and 2019, but the duration of the inversions was only 28 days and 3 days, respectively.

Second, a yield curve inversion should mainly occur through declining longer-term yield for it to signal a future recession. Such a sign implies that the monetary policy is too much for the economy to weather, and weighs on the sentiments of economic entities as well.

Third, the yield curve should be sufficiently inverted ― at least 20 basis points ― for it to be a viable indicator of a coming recession. The yield curve was narrowly inverted during 2006, but the gap once again widened to 19 basis points. During the 1998 and 2019 episodes, the extents of the inversions were a mere 7 basis points and 4 basis points, respectively, based on the maximum value.

The fear of recession is indeed rising but the recent yield curve inversion itself is still far from making it a leading indicator of a recession. The Fed can raise their FFR above neutral and cause additional fears. However, if inflation pressures wane and provide a way out for the Fed to respond nimbly afterwards, there are chances that we will be able avoid a recession during this episode.

The writer is the chief economist at Meritz Securities, Seoul