Monday, January 4, 2016

Five graphs for 2016: #5, the yield curve

 - by New Deal democrat

Every year there are certain aspects of the economy that particularly bear watching.  This week I will illustrate 5 graphs that describe particular issues facing the economy that are unusually important at this time.  Several of these will be carryovers from last year, but most will be new.

Now that the Fed has not just committed itself to raising rates, but started the process, with an apparent goal of setting short term rates ultimately at 2% or higher, the yield curve - the difference between short term interest rates and long term rates - takes on more importance, particularly since long term rates are already very low.

An inverted yield curve has been a nearly flawless harbinger of recession, with its only miss in the last 50 years being the slowdown-but-not-quite-recession of 1966.  The yield curve also inverted in 1928.  A flat yield curve conveys at least a slowdown, as was the case in 1994. The yield curve was also very briefly flat in 1930.  Please note that a positively sloping yield curve in a deflationary era does not necessarily mean expansion, as there was no inversion between 1930 and 1954.

Here is the detailed graph covering the last 30 years:

Typically as the Fed has raised the Fed funds rate, longer term rates have also risen at a slower pace -- up to a point. Under current conditions, the Fed risks inverting the yield curve if long rates do not increases.  But a large increase of, say, 2% in long rates will also choke off the expansion, as things like increased mortgage costs strangle the important housing market.  So the Fed must steer a path between Scylla and Charybdis.  The above graph will show how they are doing.