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June 17, 2006

Yield-Curve, Inflation, and Recessions: Are Recessions Necessary to Control Inflation in the US?
by Jas Jain

Note: This is an original work. Permission is granted to all to forward, post, and publish, whole or in parts, with full credit to the author.

The single most important financial market indicator to predict the two most important economic variables - the GDP growth rate, especially, recessions, and the direction of the inflation rate - is the Yield-Curve, the shape of the graph of US Treasury rates as one goes from the short-term, 3-Month to 2-Year, to the long-term, 10-Year to 30-Year, rates. This is especially true in the climate of sustained inflation, no YoY negative inflation readings, that has existed in the US roughly since 1965, when the inflation started to rear its ugly head as predicted by the Longwave economic cycle. The Yield-Curve is considered flat when the difference between the short-term and the long-term rates is insignificant and it is considered inverted when the long-term rates are lower than the short-term rates.

Fig. 1 is a picture worth a thousand words to answer the question in the title. Just look at the number of inflation peaks right in the middle of recessions and some just at the beginning of recessions. Amazing, isn't it?

The most unmistakable signal of a flat, or inverted, Yield-Curve is that the growth rate has already peaked and a recession is highly likely within the next 12 months. Even more unmistakable signal is that the rising inflation rate will start falling in 6-18 months from the date of the beginning of the inversion of the Yield-Curve.

Fig. 2 shows the graphs of the inflation rate and the yield differential, short-term (3-Month) minus the long-term (10-Year). The negative correlation between the peaks and the troughs is quite obvious. It would be even more uncanny if the yield differential were advanced by roughly 9 months.

Table 1 surmises the timings of variables under discussion for the period of sustained inflation in the US since 1965.

Table 2 presents the rough sketch of the relationship between the Yield-Differential and the future direction of the inflation rate.

Why Recessions Have Become Necessary to Control Inflation in the US?

Since the historical evidence is unmistakable we need to understand why. There are two factors at play that collude to force the observed pattern.

1. The Fed Policy

On Friday, June 16, 2006, someone (Schweitzer?) on Bloomberg TV made the following comment (emphasis is mine, although it was evident in the tone of the speaker as well):

"Fed has to CAUSE REAL PAIN to bring INFLATION UNDER CONTROL."

The reason that "Fed has to cause real pain" is because it is in the Damage Control mode after having done the damage itself by having pursued a policy of too easy a monetary policy for too long. That politics plays a role in it is undeniable, especially, in recent years. The urgency to control inflation became so great during the late 1970s that the Volcker Fed was given the free hand, including "to CAUSE REAL PAIN," without regard to the politics. And causing real pain it did - the 1980-82 Double Dip recession was by far the worst since the Great Depression. But that is what it took to bring the inflation rate down to an acceptable level.

The easy money policies of the Fed in 1960s and 1970s were nothing compared to the policies of the Greenspan Fed, especially, during 2002-04 (when a lot was at stake for Bernanke, Bush and Greenspan). The Damage Control, handed to poor Bernanke, would cause Pain commensurate with the Damage. The 5-6% Fed Funds Rate under the current level of debt would cause more pain than the 20-22% rate under Volcker because of who is the pain going to be directed at - the households. People underestimate the damage that the potential 5% of homeowners walking away from their homes, over a period of 12-24 months, would do to the financial system and the economy.

2. The Economic Cause

The easy money and lending policies by bankers, governmental as well as private, always lead to speculation in financial markets as well as in the real economy. My favorite economist, Joseph Schumpeter, called this "banker's mischief." The building boom in many countries of the world during the past four years is directly related to the easy money and easy lending policies in the US, for the most part, as well as in EU and Japan. Dubai could easily be the poster boy of this extravagant building boom. The high crude oil and gasoline prices are mostly due to the debt-induced consumption, fed by easy money and easy lending policies, in the US.

The easy money led and boom driven demand creates inflation and if the inflation lasts long enough it leads to what is called inflation expectations whereby the producers, or sellers, of goods and services think that they must keep raising prices.

THE ONLY FORCE THAT SUCCESSFULLY COUNTERS THE INFLATION EXPECTATIONS BY THE PRODUCERS IS THE SUSTAINED FALL IN THE DEMAND OF THEIR PRODUCE, GOODS OR SERVICES.

This takes place at the beginning of a recession. And the rate of inflation starts to come down. How far and for how long the inflation keeps falling is a function of how long the demand keeps falling. The best proof of this came during the 1980-82 Double Dip recession. When the inflation rate did not fall to an acceptable level, after the end of the first recessionary episode, an immediate and more severe second episode became necessary to keep the demand falling. Draconian monetary brakes were applieed to accomplish this. The demand had be kept falling to keep the inflation rate falling. A simple mixture of economics and psychology, my dear Watson.

Recessions create their own falling demand, as people lose jobs, and if the demand was over-saturated before the beginning of the recession the demand could remain low for a very long period. That is how depressions happen. And depressions create their own lowering of the demand when the depressionary psychology takes root among those who have the means to spend more. They decide that it is better to save and live modestly. Just because a McMansion in Silly.con Valley can be had for $250K, in 2008, doesn't mean that one is needed; the 3 bedrooms, 1700 sq. ft., home that is currently owned would do just fine. Even a bargain is let go. And that gives rise to even greater bargains!

The Demand Destruction would cause the next recession to turn into a depression. At that point the Fed policy becomes impotent to boost demand. And if the Federal govt. cuts taxes, cautious people decide to save all that tax cut! Only the cautious people would have most of the money to spend during a depression. And current bulls and profligates will suffer from envy.

Jas Jain, Ph.D.
the Prophet of Doom and Gloom

Copyright © 2004-2007 Jas Jain

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