26/2/2019 TheMoneyIllusion » Are “normal” yield curves actually normal?

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A slightly off-center perspective on monetary problems.

Are “normal” yield curves actually normal?

The US yield curve usually slopes upward. Hence positively sloped yield curves are termed ‘normal’ and
negatively sloped yield curves are termed ‘inverted’. But are “normal” yield curves actually normal?

The US business cycle has an unusual feature, an absence of soft landings. A soft landing is when
unemployment recovers to the natural rate, and then stays low for at least four years. The only plausible example
is 1966-69, but that wasn’t really a soft landing because it came at the expense of rapidly accelerating inflation.
The plane soared off into the stratosphere before the wheels even touched the runway. Otherwise, we have only a
year or two of stable and low unemployment, before the next recession.

He not busy being born is busy dying — B. Dylan

So 90% of the time we are either recovering (mostly with a normal yield curve) or in recession (mostly with a
normal yield curve.) Inverted curves tend to occur right before a recession, when unemployment is low. But
what if we did have a true soft landing—persistent low unemployment without accelerating inflation? Would the
yield curve be flat? After all, when output is already near the natural rate, you don’t expect further recovery. You
don’t expect the future economy to be better (stronger) than the present.

So I decided to seek out a country that did have a soft landing—Britain from 2001-08:

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2001-08: Not busy being born or busy dying

Notice that in 1991, the UK entered recession almost immediately after the unemployment rate stopped falling—
the US pattern. But in 2001, unemployment reached the low 5s and stayed near there until mid-2008. So how
about the UK yield curve? Below I have data from 2000-08, using June data in each case. The first number is the
nominal yield on 6-month UK T-bonds, and the second number is the yield on 10-year bonds. I’m not used to
using UK data, so someone tell me if I made a mistake:

2000: 6.0%, 4.13%

2001: 5.33%, 4.92%

2002: 4.38%, 4.80%

2003: 3.19%, 4.87%

2004: 4.89%, 4.93%

2005: 4.16%, 4.28%

2006: 4.70%, 4.47%

2007: 5.85%, 4.94%

2008: 5.26%, 5.12%

During these 9 years, the UK yield curve was slightly inverted, on average. But pretty close to flat. This suggests
that a flat yield curve might be expected when the economy is still expanding, but the unemployment rate is not
expected to fall much further.

Note that the US yield curve was pretty flat in May 2006, when unemployment had fallen to 4.6% and was
expected to stay around that level. And unemployment did stay around that level for another 18 months. The
yield curve was also fairly flat in 1966. The yield curve today slopes gradually upward, but it’s flat between 2
years and 5 years, which suggests to me that markets may be expecting the US to achieve a soft landing.

The unemployment rate today (4.0%) is not much different from 15 months back (when it was 4.1%.) I expect it
to fall a few more ticks (the trend is actually in the high 3s), but then stop falling. If I’m right that the US will
achieve its first ever non-inflationary soft landing, then I’d expect a pretty flat yield curve to be the new normal.
There’d still be a slight tendency for an upward slope, but not much.

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Of course this happy scenario assumes that the Fed keeps NGDP growing at a reasonably steady rate (say a
range of 3% to 5%). There are no guarantees, but they seem to be trying to do something like that in recent
years, even if they don’t admit it.

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5 Responses to “Are “normal” yield curves actually normal?”

1. John Hall
25. February 2019 at 13:22

I’m sympathetic to the non-inflationary soft landing story.

2. Brian Donohue
25. February 2019 at 13:37

Good post.

“If I’m right that the US will achieve its first ever non-inflationary soft landing, then I’d expect a pretty
flat yield curve to be the new normal. There’d still be a slight tendency for an upward slope, but not
much.”

I think we’re there. Good job Fed.

Better than May of 2006, when the Fed responded to a flat yield curve with yet another hike in the FFR (to
5.25%!), creating the inversion. Because, you know, we had to store up ammo for the recession we were
precipitating.

3. Benjamin Cole
25. February 2019 at 15:53

This may be another case in which empirical observations trump economic theory.

Or we need a new theory as to why people would be willing to lend short or long at the same interest-rate.
What happened to the term premium?

There has been the emergence and rapid growth of bond funds.

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This allows investors to invest short, that is stay liquid, while invested in long-term bonds. I suppose if
such bond funds are large and ubiquitous, they could help blur the difference between long and short-term
rates.

As an aside, Fitch Rating has fretted that such bond funds may collapse, if for some reason they suffer an
investor run. The bond funds would be attempting to sell bonds into an illiquid market for long-term
bonds, or sell at a large loss.

4. Benjamin Cole
25. February 2019 at 16:28

“The Phillips curve is the connective tissue between the Federal Reserve’s dual mandate goals of
maximum employment and price stability.”
FRBNY President John C. Williams, USMPF Discussion, February 22, 2019.

“The White House wants highly capable, competent people who understand that you can have strong
economic growth without higher inflation.” White House National Economic Council head Lawrence
Kudlow, cited in The Wall Street Journal, January 24, 2019

–30–

So who is right on this one? The dunderheads in the Trump White House or the New York Fed president?

Egads….

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5. Michael Sandifer
25. February 2019 at 16:28

Scott,

A priori, why should a yield curve be flat? Sure, maybe flat is normal if real potential GDP growth is
expected to be lower in the future, but that certainly wouldn’t have applied in the 60s as it night today.
Shouldn’t there be temporal discounting of future interest payments?

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My name is Scott Sumner and I have taught economics at Bentley University for the past 27 years. I
earned a BA in economics at Wisconsin and a PhD at Chicago. My research has been in the field of
monetary economics, particularly the role of the gold standard in the Great Depression. I had just begun
research on the relationship between cultural values and neoliberal reforms, when I got pulled back into
monetary economics by the current crisis.

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