In my previous article, “Oil prices on surprising decline,” published Oct. 10, I indicated that in order to understand the signals coming to us from a major economic variable, it is important to read the signs coming from the variables associated with it.
For example, to figure out the changes in short-term interest rates, it is useful to read the changes in long-term interest rates, the rate of future economic growth, and the inflation rate. In return, understanding the direction of interest rates may have a predictive power for future economic growth, exchange rate and inflation
Currently, some short-term rates in the United States are traded at negative yields. Moreover, the two-year interest rates are yielding negative returns in Belgium, Denmark, Finland and Netherlands. Negative interest rates are something unheard of before the 2008 financial crisis.
This means that investors are seeking safety in the short-run and seeing trouble in the economy ahead. Thus, the safest way to follow now is to buy Treasury bills, which last less than one year.
If we assess the signals coming from long-term interest rates, we can presume that those rates are hesitant to move up, thereby indicating that investors are uncertain about economic growth in the long run. Putting the short and long run data together in a curve shows that the yield curve is not steepening but rather may be flattening.
Macroeconomics tells us that flattening yield curves imply slow or declining economic growth in the near future, with the possibility that the economy may dip into recession. Reading the current anecdotal data of the state of the U.S. economy, it shows that this economy contracted by 2.1 percent in the first quarter but grew at 4.6 percent in the second quarter of 2014. Looking at the first half of this year, economic growth was 0.9 percent. A similar thing happened in 2011 after which the economy went on a roller coaster ride.
What is the implication of a flattening yield curve? It implies that there is high uncertainty about the future pace of the economy and that any monetary tightening by the Federal Reserve now is likely to slow economic growth further and may push the inflation rate lower into a dangerous zone, which could lead to deflation.
It also implies that the growth in wages will remain modest for the near future, suggesting that the consumer will continue to limp along.
The anecdotal facts also show that there is still a considerable slack of labor in the economy, despite the recent drop in the unemployment rate. There is not a noticeable rise in the wage rate, so there is no threat of cost push inflation. There is no fear of inflation rising greater than 2 percent any time soon.
Economic growth is also not accelerating. Internationally, the world’s second largest economy is slowing down and the eurozone is teetering into a new recession. The Russia-Ukraine crisis and the sanctions will also weaken economic growth in Europe and the United States.
This confluence of major global factors points to a high probability that short-term interest rates will decline after the Federal Reserve is done with its bond purchasing next month. Why is the stock market getting so jittery? Why does the dollar keep rising?
Markets do get irrationally nervous as people do. Interest rates and the exchange rate are spooking the markets.
We should be aware that the Federal Reserve does make mistakes of great proportion that can plunge the world’s largest economy into recessions. History has shown that the Federal Reserve tightened prematurely in 1937 after the economy became robust, sending the economy back into recession after struggling for several years to emerge from the 1929 Great Depression.
Given the current anecdotal facts about the U.S. economy, we can say now that it is premature for the Federal Reserve to tighten. The yield curve says: “Don’t tighten any time soon because the economy may go on another roller coaster ride which should end in a new recession.”
Shawkat Hammoudeh is a professor of economics at Drexel University. He can be contacted at [email protected]