St. Louis Fed chief warns current U.S. monetary policy could lead to “yield curve” downturn

St. Louis Federal Reserve President James Bullard warned Arkansas business leaders and bankers on Friday (Dec. 1) that if U.S. monetary policymakers continue the course of hiking short-term U.S. interest rates the nation’s economy was at risk of a “yield curve inversion,” which he called a precursor to a possible recession.

“There is a material risk of yield curve inversion over the forecast horizon if the FOMC (Federal Open Market Committee) continues on its present course of increases in the policy rate,” said Bullard. “Yield curve inversion is a naturally bearish signal for the economy. This deserves market and policymaker attention.”

Bullard, one of five Federal Reserve presidents who serves on the 19-person FOMC board that makes U.S. monetary policy, was the keynote speaker at annual economic forecasting event at the Clinton Library. The event is hosted by the Little Rock branch of the Federal Reserve Bank of St. Louis and Arkansas Economic Development Institute (AED) at the University of Arkansas at Little Rock.

As president of the Federal Reserve’s expansive Eighth District, Bullard overseas a six-state area that has branch offices in Little Rock, Louisville and Memphis, and serves the states that include all of Arkansas, eastern Missouri, southern Indiana, southern Illinois, western Kentucky, western Tennessee and northern Mississippi.

Bullard’s speech was closely watched on Wall Street with the U.S. Senate Banking and House Committee held confirmation hearings this week on the nomination of Federal Reserve Board Governor Jerome Powell to lead the U.S. central bank. Powell is on tap to replace Janet Yellen, who announced her retirement from the Board of Governors in early November, following Powell’s nomination to the past by President Donald Trump.

Under Yellen’s tenure, Bullard noted that the U.S. nominal yield curve has been flattening since 2014. While the spread between 10-year and one-year Treasury yields was nearly 300 basis points in early 2014, the spread has narrowed recently to 73 basis points.

“The FOMC has been increasing the policy rate over the last year, and thus shorter-term interest rates have been rising. At the same time, longer-term interest rates in the U.S. have not changed very much,” he explained.

In past speeches, Bullard has crossed ways with the FOMC’s policy under Yellen of continuing to gradually raise interest over the short-term. It has been predicted on Wall Street the FOMC will take Yellen’s lead and raise interest rates by another quarter point when it meets on Dec. 13.

“The simplest way to avoid yield curve inversion in the near term is for policymakers to be cautious in raising the policy rate,” Bullard stated. He noted that the St. Louis Fed’s policy rate recommendation is flat over the forecast horizon, meaning no planned policy rate increases — provided the economy continues to perform about as expected.

Another way to avoid yield curve inversion would be for longer-term nominal interest rates to rise in tandem with policy rate increases, Bullard said, but the prospects for this are minimal.

“U.S. longer-term nominal yields could move higher, but current trends seem to indicate that both the real and the expected inflation component will be subdued going forward,” said the Fed economist.

Later, the Fed hawk said the slope of the yield curve has shown to be an accurate indicator of U.S. economic activity. Prior to the previous three recessions in 1990-1991, 2001 and 2007-2009, the St Louis Fed chief said the spread between long-term and one-year Treasury yields took place.

“You don’t have to be an expert … to interpret this (trend), before every recession there is a yield curve inversion,” said the Fed economist. “This is why people worry about yield curve inversion, which thus seem to be a harbinger of a weaker economy going forward.”

Following are other comments from Bullard.
• Concerning Powell, Bullard said he has a close relationship with the Trump administration’s nominee, who has served on the Federal Reserve’s Board of Governors since 2012. Unlike Yellen and other past Fed chairman, Powell is not an economist by trade and has work in government and on Wall Street primarily as an attorney and investment banker.

“I’ve worked with him since I have been a governor and I think he’s been very good as a governor and has rolled up his sleeve and got involved in many aspects of the Fed and got to know all around the Federal Reserve system and I am looking forward to working with him as chair,” said Bullard. “He will be a steady hand.”

• When asked by an audience member how he believes the GOP’s tax reform package will impact the economy if passed by Congress, Bullard said he is not clear on what is in the legislation, and therefore, finds it difficult to make an assessment.

“But I would say in general terms the ideas behind the package are good ones. I think our corporate tax structure is out of alignment with the global tax structure and is causing U.S. corporations to do unusual things to avoid the U.S. corporate tax,” he said. “I think we can get some gains from U.S. corporate tax reform.”

Bullard said he also likes parts of the bill that will streamline the tax code for most U.S. taxpayers, including raising the standard deduction that cause fewer people to itemize their taxes and simply the way most wage earners file taxes. “I think that has a lot of merit,” he said.

Bullard hedged on whether the tax reform legislation will impact U.S. growth.

“I think it might because the basic idea of the legislation is to encourage investment in the U.S. since growth has been weak since the (recession). If we light a fire under investment …, then presumably that will lead to buying more equipment, and that will lead to higher worker productivity, and that will lead to higher growth and this will be helpful for the U.S. economy.

• Bullard frowned when he was asked about technology advances that will lead to transformative changes in financial markets, including alternative financing vehicles and currencies such as Bitcoins and other digital moneys. While he did express that digital and virtual currency is very interesting and promising, Bullard said Bitcoin and other alternative currencies do not have the full faith and backing of the U.S. government to compete with other global currencies.

“The U.S. dollar is backed by the strength of the U.S. economy, and that’s why the dollar is (Federal) Reserve currency that is used in all international transactions,” Bullard said. “So, when you look at the virtual currency …, what you are looking for is can they provide a stable value? That doesn’t bode well for the future of (Bitcoin and other virtual) alternatives as currency.”