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Why Is the Yield Curve Flattening, and What Is the Fed Doing About It?

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So far this year, the Federal Reserve has raised the interest rates twice in an effort to prevent inflation while maintaining solid economic growth. This policy makes sense for a number of reasons, including the low unemployment rate, tightening labor market, hastening CPI growth of 2.9%, and recent tax cuts.

Today, during the second day of testimony at Capitol Hill, Federal Reserve Chairman Jerome Powell said the central bank plans to raise interest rates gradually “for now.”

This is a change from past announcements from the Fed, as those didn’t have the qualifier “for now” and instead had much more certainty about plans to raise interest rates two times through December of this year. This change in sentiment can be mainly attributed to the flattening of the treasury yield curve.

A yield curve is the difference between the yield rates of two- and 10-year Treasury notes. The shorter-term rate typically climbs along with investor expectations for Fed interest rates. In other words, it moves in line with the tightening of the Fed’s monetary policy, which responds to inflation.

The longer-term rate moves in line with more macro factors, such as outlook for global economic growth. Typically, an ideal yield curve will have a gap between the two rates, with the 10-year yield being higher than the two-year yield.

As of July, the gap between yields on the two Treasury notes has narrowed to nearly 11-year lows, which signals the flattening of the yield curve. The yield curve is an important indicator of any fore coming economic downturn, as before each recession since as early as 1975, short-term rates were higher than long-term rates, resulting in an inverted yield curve.

The yield curve has flattened for a couple of reasons. First, the Treasury is selling more short-term bonds to fund tax cuts and government spending. Second, due to growing inflation and higher CPI growth, the Fed wants to prevent overheating the economy. So naturally, investors’ expectations for the tightening of Fed monetary policy heightens, which pushes the short-term rate higher.

As for the long-term rate, it has been retreating since May due to trade war fears, which may hinder global growth. Also, even after the 2017 tax cut, capital spending hasn’t been as great as expected. Additionally, as Mr. Powell has noted, new tariffs could slow the economy in general, lowering the 10-year yield, while pushing inflation higher, thus raising the two-year yield.

The flattened yield curve has been met with different reactions. Ben Bernanke, the former chairman of the Federal Reserve, remained optimistic about the economy, stating, “Everything we see about the near-term outlook for the economy is quite strong.”

While acknowledging that the yield curve is an important indicator of looming of recessions, Bernanke supported Mr. Powell and said that the Fed takes multiple factors into consideration, not just the yield curve, when making decisions about the monetary policy.

On the other hand, other Fed leaders—like the leaders of Atlanta, Philadelphia and Minneapolis Fed banks—showed signs that they may want to hold off on rate increases if it would mean inversion of the curve. Minneapolis Fed leader Neel Kashkari defended his position by saying that “there is little reason” to raise the rates if it will “trigger a recession.”

With mixed signals from the economy, both sides are definitely understandable. The economy still remains robust, but taking caution and looking out for risks never hurts.

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