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Brainard, Lael on 2018 May 31

In the median outlook in the FOMC's Summary of Economic Projections (SEP), the federal funds rate is projected to reach its longer-run value by 2019 and exceed it in 2020. If the 10-year term premium were to stay very low, that path would likely imply a yield curve inversion. But for the reasons I just noted, if the term premium remains low by historical standards, there would probably be less adverse signal from any given yield curve spread.

Historically, yield curve inversions have had a reliable track record of predicting recessions in the United States.8 Since 1960, the 3-month Treasury yield has moved above the 10-year Treasury yield before every recession except the one in 1990, and, conversely, there has only been one case where the yield curve has inverted and a recession has not followed--in 1966... As we try to assess the implications of this flattening of the yield curve, it is important to take into account the very low level of the current 10-year yield by historical standards... One reason the 10-year Treasury yield may be unusually low is that market expectations of interest rates in the longer run may be unusually low... According to one estimate from Federal Reserve Board staff, the term premium has tended to be slightly negative in recent years. By contrast, when the spread between the 10-year and 3-month Treasury yields was at its peak in early 2010, this measure of the term premium was close to 100 basis points... With a very low term premium, any given amount of monetary policy tightening will lead to an inversion sooner so that even a modest tightening that might not have led to an inversion in the past could do so today... A second reason the term premium may be lower than in the past is the changing correlation between stock and bond returns, likely caused by changes in expected inflation outcomes. While in the 1970s and 1980s stock and bond returns tended to be positively correlated, more recently the correlation has tended to be negative. With an inverse correlation, bonds recently have been a good hedge for stocks, and that correlation may have contributed to lower bond term premiums by increasing the demand for bonds as an instrument for hedging portfolio risks... In the median outlook in the FOMC's Summary of Economic Projections (SEP), the federal funds rate is projected to reach its longer-run value by 2019 and exceed it in 2020. If the 10-year term premium were to stay very low, that path would likely imply a yield curve inversion. But for the reasons I just noted, if the term premium remains low by historical standards, there would probably be less adverse signal from any given yield curve spread. Brainard, Lael

Forecasters Club of New York

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