Beat the Press

Dean Baker's commentary on economic reporting


The Inverted Yield Curve and Other Economic Fads

Remember the inverted yield curve and the hoola hoop? A few months back, the prospect of an inverted yield curve was seen as an ominous warning sign of bad times ahead. An inverted yield curve was supposed to signal an upcoming recession. This seems worth mentioning now because the yield curve is becoming seriously inverted as long-term rates have edged downward, even as short-term rates remain relatively high.

For those who have better things to do with their time, an inverted yield curve refers to a situation in which short-term interest rates are higher than long-term interest rates. This reverses the normal course of events – typically investors expect to get a higher rate of return if they agree to lock up their money in a long-term bond or time-lock account rather than keeping it in a checking account where they can get immediate access. A few months back, as the Fed was raising short-term interest rates, without much increase in longer term rates, many market analysts raised the prospect that the yield curve would become inverted and that the economy would therefore sink into recession.

This discussion made for painful reading. There is no mysterious incantation that leads an inverted yield curve to do any special damage to the economy. The actual story here is rather simple. Inverted yield curves almost always (I say “almost” in case I missed one) come about because the Federal Reserve Board raises short-term interest rates in an effort to slow the economy and raise the unemployment rate. Sometimes the Fed goes too far and throws the economy into a recession. It is not the inverted yield curve that causes the recession; it is the fact that the Fed raised interest rates by too much. Whether the short-term rate stays 0.1 percentage point above or below the long-term interest rate cannot possibly make any difference when it comes to the probability of a recession.

With the 10-year Treasury bond rate hovering at 5.0 percent and the Federal funds rate at 5.25 percent, we might expect the inverted yield curve folks to be warning of impending disaster. However, this line is apparently no longer in fashion, or at least not in the business pages of the country’s major newspapers.

My other favorite recent fashion in economics dates back two years. In the summer of 2004, bond yields (interest rates) regularly fell on reports of higher oil prices. This was confusing to me since I’m an old-school type that tends to think that higher inflation is associated with higher interest rates, and higher oil prices mean higher inflation.

The economic fad of 2004 held out the opposite chain of causation. According to this story, rising oil prices pulled money out of consumers’ pockets, thereby slowing the economy. Since the economy was already slowing, the Fed would feel less need to raise interest rates.

This one never made much sense (don’t investors still care about the real return they get on their money?), but the story frequently appeared in the NYT and other papers. It also seemed to explain bond price movements at the time. Fortunately, this fad seems to have disappeared without a trace. Oil prices have shot through the roof in the last two years, and interest rates are …….. much higher. I am not surprised.


  • At 12:06 AM, Anonymous howard said…

    but it seems to me, dean, that the term that is used wrt the inverted yield curve is that it "signals" a recession, not that it "causes" one.

    and i happen to think that signal still has a pretty good chance of being correct, regardless of whether the wsj or the nytimes had an article about it recently or not.

  • At 12:22 AM, Anonymous Dirk van Dijk said…

    The general economic function of banks is to borrow short (ie checking deposits) and lend long (ie car loan, mortgage etc). While an individual bank can hedge itself six ways to sunday, doesn't this still basically describe the banking system as a whole. If so, an inverted or flat curve, especially one that lasts for a protracted period would ahve the effect of causing banks to refrain from lending and thus slow things down.

  • At 6:38 AM, Anonymous Anonymous said…

    "Sometimes the Fed goes too far and throws the economy into a recession."
    THIS time the Fed has been way too lax for way too long & a recession is the ONLY way out. The alternative would call for the Fed to support a housing sector that's doubled (& in many cases tripled) in 5 short years, while wage growth has been stagnant. Even the Fed can't print that much money!
    If you're inclined, love to hear your thoughts on Peter Warburton's, "Debt & Delusion".

  • At 4:48 PM, Anonymous Anonymous said…

    "Whether the short-term rate stays 0.1 percentage point above or below the long-term interest rate cannot possibly make any difference when it comes to the probability of a recession."

    For what it's worth, the argument I've read in various newspapers is that, under an inverted yield curve, long term lending gives way to short term lending. So businesses which want to borrow money for the long term to invest in new equipment, plants, IT infrastructure, or whatever have to pay more to do it, and so less investment happens, slowing down the economy.

    It doesn't sound unreasonable to me, though I too question how large a recession a ten basis point difference in long/short rates can cause.

    Still, Dean, I'm afraid I don't quite see how your blog posting rebuts this particular notion. You're just asserting that it "cannot possibly make any difference."

    Please elaborate.

  • At 10:39 AM, Blogger Dean Baker said…


    I don't know of any theory that has investment, or any other component of demand, being hugely responsive to small changes in the interest rate. While the mix of long-term and short-term rates can affect investment, I don't know of any theory that would hold for a given short-term rate, that we would have more demand with a higher than lower long-term rate. That is what the inverted yield curve implies.

    I'm open to create economic stories, but someone at least has to put it one the table -- to date they haven't.

  • At 4:48 PM, Anonymous Anonymous said…

  • At 9:59 AM, Anonymous Anonymous said…

  • At 6:41 PM, Anonymous Anonymous said…

    Many people here it seems have no grasp of what those rates mean.

    First, the rates quoted are the BENCHMARK rates on the highest quality debt. Therefore, they set the minimum interest rates, NOT THE MAXIMUM! - nothing can prevent one from lending for 30 years out at 20% a year even if the TYX bond yields 4.8% - if there is sufficient demand for credit. Everybody should understand that.

    Second, the reason for the predictive power of the yield curve is NOT simply because of the actions of the Fed. Steepening or flattening, and possibly inverting of the yield structure is often due to natural liquidity preferences. If lenders believe the economy will do great, the yield curve steepens, if they believe it won't do great, it flattens/inverts because the capital flows out of lending and into the safe government bonds.

    These two points make it clear that the inverted curve does NOT prevent anyone from lending - the power of the yield curve is in its PREDICTIVE gauging of demand for credit.

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  • At 8:50 AM, Anonymous worldpeace said…

    The recession looks very eminent. It is really time to take pro active steps to avoid a painful time in the next two years which is howlong the recession is expected to last.

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