MNI INTERVIEW: Flat US Yield Curve May Mean Rates Near Neutral

By Jean Yung

     WASHINGTON (MNI) - The flattening U.S. yield curve may be reaching a

tipping point after which any further compression will have an outsize negative

impact on labor markets, the Dallas Fed's principal monetary policy advisor Evan

Koenig told MNI, citing research indicating the Federal Reserve may be close to

neutral levels of interest rates.

     History shows unemployment rises more sharply after the spread between

1-year and 10-year Treasury yields falls below 33 basis points, Koenig said in

an exclusive interview Monday. The difference is currently just 28 basis points,

and further increases in the benchmark fed funds rate, which influences the

short end of the curve, would compress this still further.

     The Federal Reserve has put rates on hold in light of rising risks to

growth and an expected slowdown in first-quarter GDP growth. Several officials

have emphasized that yield-curve inversions -- when the spread turns negative,

with the 10-year yielding less than the shorter-term bonds -- have reliably

predicted coming recessions. The research by Koenig, who said that the 10-year

yield tends to approximate neutral levels of interest rates, adds more reason to

be cautious.

     "The yield curve doesn't have to invert to get to that point where the

economy becomes more sensitive to policy changes," Koenig said. "We are at the

point where if the yield curve flattens, you can expect a stronger response to

the economy going forward than we've seen so far."

     --'EXTRA CARE'

     Data suggest an empirical relationship between changes in the unemployment

rate and the flatness of the yield curve. What's more, unemployment responds

much more strongly to a flat or inverted yield curve than to a steep yield

curve, according to Koenig and co-author Keith Phillips, another Dallas Fed

economist.

     The economy "seems to shift into a different gear" when the yield gap

between 1-year Treasury bills and 10-year notes falls below 33 basis points,

coinciding with a more rapid rise in the unemployment rate, he said.

     "As the yield curve flattens and becomes nearly flat or inverts, you can

expect a stronger response in the economy to changes in monetary policy," he

said. "Because of this change in responsiveness, you have to exercise extra

care."

     --CLOSE TO NEUTRAL

     An inverted yield curve likely signals that monetary policy has become

restrictive. If the inversion is large or sustained, a rising unemployment rate

is likely to follow, he said.

     But with little sign of fresh inflationary pressures, policymakers are

poised to maintain rates at the low end of the neutral range for the foreseeable

future. That in turn reduces the chance the yield curve would flatten so much

that it would threaten labor markets.

     As Fed Chair Jay Powell told lawmakers last week: "With our policy rate in

the range of neutral, with muted inflation pressures and with some of the

downside risks we've talked about, this is a good time to be patient and watch

and wait and see how the situation evolves."

--MNI Washington Bureau; +1 202-371-2121; email: jean.yung@marketnews.com

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