Yellen: The Relationship Between The Slope Of The Yield Curve And The Business Cycle May Have Changed

Markets are pricing in less than two rate hikes for 2018 in the aftermath of yesterday’s FOMC rate decision and press conference. Yet, the biggest takeaway from Chair Yellen’s press conference was her belief that there are “good reasons to think the relationship between the slope of the yield curve and the business cycle may have changed.” To me, this suggests that Fed officials MAY be inclined to disregard a flattening yield curve as a market signal and hike more aggressively. Some thoughts below

You know my baseline view here: I think the economy is doing well and we could even hit 3% year-on-year growth after Q1 2018 figures are released. The flattening yield curve doesn’t worry me yet because shallow isn’t the same thing as flat and flat isn’t inverted. But I lean more toward St. Louis Fed President Jim Bullard’s view than I do outgoing Fed Chair Yellen’s. Earlier in the month, Bullard was quoted in Bloomberg saying, “there is a material risk of yield curve inversion over the forecast horizon if the FOMC continues on its present course of increases in the policy rate.” The quote continues with him warning, “yield curve inversion is a naturally bearish signal for the economy. This deserves market and policy maker attention.’’

I think Bullard is exactly right. If the economy proceeds as I believe it will we will get 3 rate hikes in 2018, maybe even 4 — not the two currently priced in. And this is because the Fed has shown in its forecasts released yesterday that the unemployment rate is already below the so-called the non-accelerating inflation rate of unemployment. Now, NAIRU is a made-up target that doesn’t have much credibility with me. But it does drive many Fed economists’ thinking about how to deal with the Feds dual mandate. And with the Fed forecasting unemployment falling from 4.1% to 3.9% by year end, when its stated NAIRU is 4.6%, you’ve got the makings of 3 or 4 rate hikes next year.