Fed blunders created the inverted yield curve

by Trade Correspondent L.C. and the Editor

Of the two threats to continued growth of the US economy — the inverted yield curve and the US-China trade war — the first is the most immediate threat and has been fostered by flawed Federal Reserve policy. By accelerating and deepening investor concern, the inverted yield curve has created the danger of a recession that would not otherwise exist.

An inverted yield curve comes about when the interest on 10-year Treasury bonds is lower than that on 3-month Treasury bills. Today, 10-year Treasuries are paying 1.60% and 3-month T-bills a higher 1.94%.

How did this happen, and is it really an infallible sign of an imminent recession? As George Selgin, director of the Center for Monetary and Financial Alternatives at the Cato Institute, explains, the statistical correlation between an inverted yield curve and a recession is imperfect and basically a post hoc ergo proper hoc explanation. But if enough people believe the correlation to be causal, it can become so by creating a panic.

The present inverted yield curve was created by wrong-headed Federal Reserve policy that deliberately pushed down long-term interest rates, while at the same time preventing short-term rates from sinking lower. The Fed pushed down long-term interest rates by its unprecedented policy of buying long-term mortgage bonds for its portfolio (“quantitative easing”) and then suddenly halting its expected sale of those bonds once strong US economic growth had resumed. At the same time, the Fed buoyed up short-term interest rates by means of another unprecedented policy: paying interest on reserves that banks placed with the Fed.

While President Trump’s trade war with China and other countries has reduced economic growth by creating uncertainty for investors and increased costs for many businesses and consumers, it will not by itself cause a recession. But bad monetary policy can and will. It did so in 2008, catalyzing the Great Recession. And at other times as well.

The Fed was the 1914 creation of President Wilson and the Progressive movement. They were able to enact a bill creating this unaccountable “Fourth Branch” institution because the Republican Party was willing to sell its birthright — opposition to the Fed — in return for increased tariffs the country didn’t need.

If the Fed succeeds in catalyzing another recession or Depression, that will be yet another scripted monetary disaster just before an election, insuring the defeat of the Republican incumbent or his successor.

Consumer tariff delay

Meanwhile, on the trade front, last Tuesday the White House announced a delay in imposing some of the threatened tariffs on China out of concern that increased prices on consumer goods would dampen the Christmas shopping season. Some members of the president’s amen chorus accuse him of weakness for this reversal. But consumer spending has been holding up the US economy in the face of weakening manufactures and capital spending. Trump coal in Christmas stockings would not have been a smart political move either.

Further complicating US-China relations is the crisis in Hong Kong. Many US politicians and officials would like to show support for the protesters but understand that this could serve to undermine them and give Xi grounds for accusing them of being used by Washington. President Trump has belatedly warned China that brutal suppression of the Hong Kong demonstrators would set back US-Chinese trade negotiations. “China wants to make a deal. Let them work humanely with Hong Kong first,” he tweeted on August 14th.

There’s no reason prosperity can’t continue in the US. But the Fed will need to back off the policies that caused the present yield curve inversion, and President Trump will need to wind up his investment-damaging trade wars: first of all, by concluding trade pacts with allies and, secondly, settling the US trade war with China in a way that curbs China’s extensive mercantile practices but only blocks trade totally in products of military or intelligence significance.