As far as policy goes, this situation presents an argument for two things: (1) for no more rate hikes and (2) for the Fed to cut rates. If the Fed cuts rates 25 basis points, a quarter of a percentage point, that would take the curve positive again. More cuts would mean an even more stimulative monetary policy. The idea is that this policy would avert a recession, so the Fed should get going immediately. It is also what’s driving current market expectations of an imminent rate cut.
Not So Simple
Unfortunately, it isn’t that simple. The Fed isn’t stupid. In all previous inversions, it did cut rates—substantially. The problem is that, in the past couple of decades, cutting rates after the inversion has not been sufficient in averting a recession. It worked in the 1980s and 1990s, but it didn’t work in the 2000s. The reason is not entirely clear, but it is likely due to how much lower rates are now than they were then. As rates get lower, the Fed has less room to cut, and the incremental benefit of a cut gets smaller. With rates at current levels, there simply isn’t much alcohol left in the bottle that the Fed can add to the punch bowl.
This is the problem the Fed now faces: cut rates immediately, which likely won’t avoid a recession and will exhaust limited ammunition, or wait until the recession actually starts to hit and then use the rate cuts.
What About A Pending Recession?
Either way, a recession looks increasingly likely, but not immediately. Interestingly, a recession usually starts only after the rate cuts actually happen and the yield curve un-inverts. This is what I will actually be looking for as a much more timely signal of the pending recession: not the inversion but the reversal (again, as you can see in the chart). This situation is just one more example of how economics often works very differently than what you might think!
The Fed is in a tough spot, exacerbated by current political pressures and trade war concerns. But the real takeaway is that it may not matter that much what the Fed does. We have to listen and respond, but we also need to mind the big picture.
Brad McMillan is the chief investment officer at Commonwealth Financial Network.