Traders work as Federal Reserve Chair Jerome Powell makes a remark on a screen at the New York Stock Exchange (NYSE) in New York City on March 16, 2022.
Brendan McDermid | Reuters
All eyes are on the yield curve between the 2-year and 10-year Treasuries, but investors are watching closely for the wrong signal.
As I mentioned earlier, the authors of the Federal Reserve’s studies on the so-called slope of the yield curve do not consider it to be inverted (and indicative of an imminent recession) until the three-month Treasury yield is above that of the 10-year note.
The curve is nearly flat from two-year to 10-year maturities, but that’s not the metric the Fed monitors most closely.
Right now, the spread between the 3-month bill and the 10-year note is nowhere near inversion. However, if the Fed becomes more aggressive in raising short-term rates, we could get there sooner rather than later.
The lead time between a full inversion and a recession is around nine to 15 months. On average, the period is about 12 months.
That means we have a little time before we get really concerned about an imminent recession.
Today’s real-time economic reactions to Fed policy
There is another interest rate issue that has been bothering me for some time.
In this real-time world, economists continue to insist that there is a significant lag between changes in Fed policy and their impact on the real economy.
I doubt that’s true in today’s world.
When I first got into business journalism in 1984, it was common to believe in a time lag between policy change and the actual economic impact.
Back then and until relatively recently, the Fed only acknowledged changes in policy with hindsight or with a simple press release with few details.
The legion of so-called “Fed watchers” who emerged during this period had to follow the Fed’s open market actions on a daily basis.
Every day around 11:30 a.m. ET, the Fed added or drained liquidity from the banking system. Sometimes the additions or deductions were temporary to address cash imbalances in the banking system.
Permanent additions or subtractions could indicate changes in policy that would be confirmed much later.
Fed watchers also tracked the rise or fall in the money supply when those numbers were released each Thursday afternoon.
It took weeks, if not months, for some consumer rates to change, affecting markets and consumer spending and saving behavior before anyone found out that policy had changed.
Today, the Fed announces changes in real time, takes reporters’ questions to explain its decisions, and communicates between meetings to alert markets and consumers to upcoming shifts in central bank thinking.
This has a direct impact on the economy.
For example, in the 1980s, mortgages were tied to several different interest rates, one of which was referred to as the 11th Circuit Cost of Funds.
This rate was updated monthly, so movements in mortgage rates lagged changes in Fed policy for some time.
Today you can see daily mortgage rate changes online.
Consumers are responding to stricter policies
Pending and existing home sales and mortgage applications have tumbled in recent weeks with only one rate change announced and in anticipation of bigger and more frequent rate hikes in 2022.
I have suggested that the Fed should normalize rates given the strong economy and rising inflation are key factors in its decision tree. However, the speed at which policies are now affecting the economy would also suggest that the Fed should exercise caution when it comes to raising interest rates and trimming the balance sheet.
Indeed, with fiscal policy now at least partly geared toward deficit reduction, near-simultaneous monetary tightening could plunge the economy into recession, especially given all the other risk factors facing the economy. These risks range from the ongoing war in Ukraine to renewed Covid lockdowns in China and restrictions in Hong Kong.
While critics continue to stalk the Fed from a policy standpoint, few have warned that the most antiquated idea isn’t whether the central bank is behind the curve, but whether the curve now looks more like a fastball.
Curve issues are important, but the Fed’s fastballs could throw the economy right out of the batter’s box.