If the Federal Reserve continues to raise the federal funds rate target, it risks inverting the yield curve, often seen as a precursor to recession, Federal Reserve Bank of St. Louis President James Bullard said Friday.
“There is a material risk of yield curve inversion over the forecast horizon if the FOMC continues on its present course of increases in the policy rate,” Bullard said at regional economic briefing in Little Rock, according to text released by the Fed. “Yield curve inversion is a naturally bearish signal for the economy. This deserves market and policymaker attention.”
Bullard has long suggested rates can stay where they are for the foreseeable future as long as the economy performs as expected and inflation remains below trend.
If longer-term nominal yields rise together with the fed funds rate, an inverted yield curve could be avoided. But, he noted, “this seems unlikely as of today.”
The best way to prevent inversion, “is for policymakers to be cautious in raising the policy rate,” Bullard stated. “Given below-target U.S. inflation, it is unnecessary to push normalization to such an extent that the yield curve inverts.”
The yield curve has been flattening since 2014, with the spread between 10-year and one-year Treasury yields dropping from nearly 300 basis points to 73 basis points recently, he said.
“The FOMC has been increasing the policy rate over the last year, and thus shorter-term interest rates have been rising,” Bullard noted. “At the same time, longer-term interest rates in the U.S. have not changed very much.”
While an inverted yield curve does not necessarily translate into a recession, it could suggest lower growth and dampened inflation levels.
“To be sure, yield curve information is not infallible and inversion could be driven by other factors unrelated to future macroeconomic performance,” he said. “Nevertheless, the empirical evidence is relatively strong. Therefore, both policymakers and market professionals need to take the possibility of a yield curve inversion seriously.”