James Bullard is the president of the Federal Reserve Bank of St. Louis.  He is currently an alternate member of the Federal Open Market Committee (FOMC).  This makes him an influential economist. He is part of the establishment, but it is wise to listen to what he saying.

Bullard recently said in an interview that he would prefer for the Fed not to raise interest rates (the federal funds rate) any more this year.  He said he does not see the need for higher rates given that inflation is not running high.

He then commented about the flattening yield curve.  He said that it was a mistake for the Fed to have kept raising rates in 2006 when the yield curve inverted.  Then he said about an inverted yield curve, “This time, I want to take this signal seriously.”

He goes on, “There is no reason to challenge the yield curve at this time.  There’s no reason.  In other circumstances, if inflation was higher and heading higher, then I might say, well, we’re taking some recession risk but I’m willing to trade that off because it looks like inflation is getting out of control. We’re not in that situation today. Inflation is low.  It’s stable.”  He goes on, “We don’t need to challenge; we don’t need to be preemptive on the yield curve.”

Bullard made similar comments in another interview saying that we shouldn’t challenge the yield curve, meaning he doesn’t think the Fed should push short-term interest rates any higher at this time.

The yield curve has been a great predictor of recession.  When it inverts (long-term rates fall below short-term rates), it indicates a recession is coming, and it has historically been quite accurate.  So what if the Fed were to react to the yield curve?  It could stop tightening when the yield curve is flat.  It could even loosen if the yield curve is flat or inverted, anticipating a recession.  Would that in itself ruin the yield curve as a recession indicator?

I was a bit surprised that Bullard made these comments.  It’s not that he and other Fed members don’t think such things, but I am just surprised he said it out loud in a public interview.  While he is just one person, he is one of twelve people on the FOMC.

First, what are the chances that the FOMC voting members would actually follow the yield curve and let it influence their votes?  This is certainly possible, as Bullard has alluded to.  But I would be surprised if they were forthright about it.

Here is the thing. The Fed never predicts a recession or issues some kind of statement saying that a recession could be imminent.  It just doesn’t happen.  They will use technical jargon and say that the economy is softening or that growth may be slowing. But you never hear the Fed chair say that we should be worried about a coming recession.  You never read an FOMC statement saying that the Fed is loosening to prepare for a recession in the near future.

Even if they thought this, they would never say it.  Because if they were correct and a recession came, then the president, Congress, the financial media, and most of the American public would actually blame the Fed for causing the recession.  (They might be correct, but for the wrong reasons.)  They would say that the Fed caused the recession by making people worry about it and caused them to stop spending money. People would say that the Fed created a self-fulfilling prophecy.

Therefore, if the Fed is going to stop its tightening, let alone actually start loosening again, it would need a good excuse.  The Fed members are not going to say that they are loosening monetary policy because of an inverted yield curve that is making a recession look imminent. They would have to come up with another excuse, and it wouldn’t be easy to do in this economic environment with low unemployment, new stock market highs, and relatively low inflation (at least according to the government statistics).

And even if the Fed were to loosen in reaction to an inverted yield curve, would it actually prevent the recession from happening?

This depends. Most likely, it would not stop the recession from coming in the near future.  The malinvestments from the previous loose monetary policy have already begun to be exposed in this scenario.  If you remember the financial crisis of 2008, the housing prices started coming down about 1 to 2 years before that.  If the Fed had started printing (digitally speaking) money in early 2008, I don’t think that would have stopped the housing bust from happening, and it probably wouldn’t have prevented the meltdown in stocks.

Of course, it does depend on just how much the Fed were to react.  If the yield curve were to invert and the Fed were to announce QE4 where it increases its balance sheet by $200 billion per month, then sure, that may be enough to stave off the coming recession temporarily.  You can stop the patient from its drug withdrawal symptoms by overdosing the patient with the drug.

If the Fed were to react this dramatically, then there would obviously be other, and more severe, consequences.  We would probably get high consumer price inflation.  We would most certainly get more malinvestment on a greater scale. And when the inevitable recession finally did come, it would be that much more severe.

In conclusion, I don’t think the Fed is going to loosen policy based on a flat or inverted yield curve.  The Fed may stop hiking its target federal funds rate.  Maybe it would stop its balance sheet reduction.  But I highly doubt it would start another round of QE or lower its federal funds rate unless we are actually in a recession.

If the Fed were to take unprecedented and dramatic steps based on the yield curve alone, then we will be in uncharted waters.  But I still don’t think it would prevent the coming recession.