Why Bullard sees the yield curve inverting

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The Federal Open Market Committee needs to be cautious on monetary policy or the yield curve could invert, Federal Reserve Bank of St. Louis President James Bullard said Friday.

“There is a material risk of yield curve inversion over the forecast horizon (about 2 ½ years) if the FOMC continues on its present course,” Bullard told the Glasgow-Barren, Ky., County Chamber of Commerce, according to text released by the Fed. “Yield curve inversion is a naturally bearish signal for the economy. This deserves market and policymaker attention.”

Late last year, Bullard raised the issue and the yield curve has flattened further, “and imminent yield curve inversion in the U.S. has become a real possibility,” he said.

The yield curve inverts when short-term government debt offers higher yields than longer-term debt, and is believed to signal a coming recession.

“The simplest way to avoid yield curve inversion in the near term is for policymakers to be cautious in raising the policy rate,” he said, noting the St. Louis Fed’s policy rate recommendation calls for no rate increases in the near term if the economy performs near expectations.

“It is possible that yield curve inversion will be avoided if longer-term nominal yields begin to rise in tandem with the policy rate, but this seems unlikely as of today,” he said.

The U.S. nominal yield curve has been flattening since 2014 and the Fed started raising the fed funds rate in December 2015, thus increasing shorter-term interest rates. “At the same time, longer-term interest rates in the U.S. have not risen as rapidly,” said Bullard, who is not a voter on the FOMC this year.

If longer-term yields hold and the FOMC raises rates twice more this year, Bullard noted, the yield curve could invert late this year.

The reason it makes sense that an inverted yield curve signals a coming recession, he said, since “lower longer-term nominal interest rates may be a harbinger of both lower growth prospects and lower inflation in the future.”

Bullard used the spread between 10-year and one-year Treasury yields, but, he noted, “switching to somewhat different measures tends not to change the broad macroeconomic interpretation.”

The FOMC’s summary of Economic Projections created a situation where the focus is on a number of rate hikes over the forecast period, which he said is like a calendar-based policy rather than data-driven. “Instead, reacting to macroeconomic events should be the basis for the FOMC’s decisions on the policy rate,” he said.

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Monetary policy James Bullard Federal Reserve Federal Reserve Bank of St. Louis FOMC