MNI INTERVIEW: US Curve Sends Recessionary Signal-SF Fed Econ

Signals from the financial markets suggest the U.S. economy is headed for recession amid signs monetary policy is passing through quickly, despite ongoing uncertainty over the outlook for growth and the real rate of interest, an economist at the Federal Reserve Bank of San Francisco told MNI.

While measures of markets’ risk appetite such as excess bond premium and the unemployment rate paint a more positive picture, they are not as reliable at predicting where the economy is headed as the yield curve, which currently signals a period of economic contraction, SF Fed senior research advisor Michael Bauer said in an interview.

“The slope of the yield curve is certainly one of the most reliable, if not the most accurate predictor of recessions. We've never had a postwar US recession that wasn't preceded by an inverted yield curve. It doesn’t really matter whether you look at the 10y-3m or, as the market does, the 10y-2y -- the signal is pretty clear,” Bauer said.

TRANSMISSION QUICKENING

Bauer also chimes in on the speed of policy transmission, erring towards the idea that it is quicker this time in the United States, but there were many factors to note alongside the anticipatory effect of changes in the policy rate on long-term rates -- which might indicate that the monetary policy stance was more restrictive “quite a while” before the Fed funds rate did. (See MNI POLICY: Fed Worried Shorter Lags Require More Tightening)

“You really want to look at real interest rates and compare that to some notion of the neutral real interest rate. Depending on how you measure them, in the US they might be in the range of 2-3%, which the New York Fed suggests means the (real) neutral rate may be in the zero to 1% range,” he said.

“But it's not so clear how long this has actually been the case; how long r has been higher than r*, so maybe that's a caveat, indicating a restrictive stance,” Bauer added.

“The third piece of the puzzle is broader financial conditions, and here I have some research that says all you really have to think about is how does risk appetite change in financial markets in response to monetary policy,” he added.

Bauer’s own recent research with University of California professor Eric Swanson suggests the effects of changes in monetary policy on the real economy show up “pretty much right away,” he said, although post-Covid data presents challenges.

Within a year, most of the impacts on inflation, employment and output will have been seen, although there are caveats, Bauer said, noting the data was historical averages, using the last four or five decades of macroeconomic data. Now he is looking at new research that uses more high frequency data that actually finds transmission has really fast effects.

FED AND MARKETS SPLIT

Differences between the Fed’s more hawkish tone and markets’ earlier pricing-in of rate cuts need not point to a potential breakdown in the effectiveness of the monetary policy transmission mechanism, Bauer said. Rather, he noted, they may be the product of high levels of uncertainty linked to the variety of plausible future economic scenarios.

“Is there a divergence that could cause some problem for monetary policy transmission? I would flip this on its head and say … its tremendous uncertainty that could be one of the reasons for any discrepancy that you might see.

“But is there really a discrepancy? If one were to look at the dot plot and then compare that to market pricing, the dispersion of the dots has actually risen and reflects this rise in uncertainty. So it’s really not so surprising that market pricing could be further away from the median of those dots,” he concluded.