Here’s Tim Duy at Bloomberg:
It was supposed to be easy. When the Federal Reserve started hiking the federal funds rate, longer-term interest rates would rise. After all, they were at very low levels, restrained by a low-term premium. The “Greenspan conundrum” of the past two cycles, when long rates failed to respond in line with higher short rates, couldn’t happen a third time in such circumstances. But it didn’t work out that way. Short rates continue to gain on firming expectations of tighter Fed policy while long-rates stubbornly track sideways.
How many times does this have to happen before people stop assuming that higher interest rates represent tighter money? In fact (as Duy suggests) a tighter monetary policy will often put downward pressure on longer term rates (relative to short rates):
We shouldn’t be surprised by the flattening yield curve. That is what typically happens during tightening cycles and there was no reason to think it would not be the case this time.
Longer term bond yields tend to track expected long-term NGDP growth, although of course other factors also play a role. But expected NGDP growth is by far the most important factor, and largely explains why long-term rates are much lower than during 1972-81, when NGDP was growing at double digit rates. And tighter money tends to slow expected NGDP growth.
The yield curve is one of the better predictors of the business cycle, but it’s not perfect. The current yield curve is flatter than usual, but not flat enough to predict a recession. (Research suggests that it would need to be substantially inverted to signal a recession is more than 50-50.) Given that stocks are doing quite well, I’d say that the consensus view of the financial markets is that a recession is unlikely during the next few years, but not impossible.
Duy also points to the continued undershoot of inflation:
Arguably, though, the Fed only reinforces expectations that 2 percent is a ceiling with its commitment to rate hikes even as inflation remains below that level. In fact, monetary policy makers appear dead set to continue rate hikes next month, and into 2018. The message sent is that they stand ready to snuff out any expansion that threatens to push inflation above 2 percent.
It’s difficult to evaluate Fed policy in isolation; one needs to consider the regime over an entire business cycle. Thus the current sub-2% inflation rate is entirely consistent with the dual mandate, assuming that inflation is appropriately countercyclical (which is what the mandate implies.) But in the past inflation has tended to be procyclical (in violation of the dual mandate), in which case current policy is inappropriately tight.
So how do we know if the Fed policy today is appropriate? We don’t know, and won’t know until the next recession. If inflation rises during the next recession, then current policy will have been appropriate—even though inflation is now under 2%. If inflation falls during the next recession then current policy will have been inappropriately tight. Based on past experience, the latter assumption is more plausible, but again, current policy is exactly right if the Fed were taking its dual mandate seriously. That mandate calls for slightly above 2% inflation during periods of high unemployment, and slightly below 2% inflation during periods of low unemployment. And right now unemployment is well below average. The dual mandate calls for sub-2% inflation at this point in time.