Is The Yield Curve Sending A Dangerous Message?

The current economic, inflation, and interest rate cycle has been extremely unusual, driven by the worst global pandemic in over 100 years. Governments around the world reacted in a variety of ways. In the US, one of the governmental responses was to create negative real interest rates as well as issue record amounts of stimulus money into the economy. The US Federal Reserve, uncertain about the outlook for the economy and the affect Covid would have on the consumer and businesses, was fearful to raise interest rates and choke off any economic recovery. As a result, as inflation moved higher in the US, driven by the end of Covid lockdowns and aided by the previously mentioned government stimulus and negative real rates, the Federal Reserve did not react promptly. This resulted in a large gap between the Fed Discount rate and inflation. As seen in Figure 1, the gap reached record levels in 2022 and left the Federal Reserve greatly behind the current economic conditions.

The current economic, inflation, and interest rate cycle has been extremely unusual, driven by the worst global pandemic in over 100 years. Governments around the world reacted in a variety of ways. In the US, one of the governmental responses was to create negative real interest rates as well as issue record amounts of stimulus money into the economy. The US Federal Reserve, uncertain about the outlook for the economy and the affect Covid would have on the consumer and businesses, was fearful to raise interest rates and choke off any economic recovery. As a result, as inflation moved higher in the US, driven by the end of Covid lockdowns and aided by the previously mentioned government stimulus and negative real rates, the Federal Reserve did not react promptly. This resulted in a large gap between the Fed Discount rate and inflation. As seen in Figure 1, the gap reached record levels in 2022 and left the Federal Reserve greatly behind the current economic conditions.