InCognito

There is nothing like the joy of Fed watching. Interest rates rise and fall based on expectations of the growth rate in expenditures across the economy. Changes in expenditures tend to reflect changes in the expected return to investment in capital.

This relationship is complicated by the time to maturity for a given bond. The interest rate on the 1 Year U.S. Treasury, for example, reflects expectations of economically significant events over the course of the next year. Further, short-term debt tends to reflect changing demand for liquidity during that period. As you might expect, long-term maturities, like the 30 Year U.S. Treasury, reflect expectations of nominal income growth over a much longer period.

This has made reading the inverted yield curve a mystery for those who do not regularly think about interest rates in terms of the Fisher effect: the nominal interest rate reflects expectations of the sum of the expected real rate of return and the expected inflation rate over the life of the loan.

When the expected rate of inflation rises, so too do interest rates. However, when the expected rate of inflation over the next few years is significantly higher than the expected rate of inflation over the next 2 decades, interest rates on short-term loans may rise above interest rates on long-term loans. This is precisely what has occurred in the recent yield curve inversion. As inflation began increasing in summer 2021, long-term yields also began rising. When the Federal Reserve began tightening policy by reducing the balance sheet, slowing the growth of currency in the financial system, and raising interest rates, investors' faith in the Federal Reserve to quell the rate of inflation over a long period of time increased. Longer-term interest rates steadied. As the Federal Reserve continued raising the federal funds rate, yields on short-term loans began to exceed rates on longer-term loans. Powell had succeeded in stabilizing long-term inflation expectations.

Now multiple measures of inflation are nearing the Fed's 2% target. In fact, in recent months, the annualized 3-month rate of inflation has been below 2%. With the unemployment rate reaching the natural rate and inflation below target, the Federal Reserve has begun to reduce the federal funds rate target.

Very likely, this will continue, with the Federal Reserve slow reducing the federal funds target as long as inflation remains low and unemployment is not below the natural rate. Tomorrow, the Atlanta Fed's interest rate forecast predicts that, tomorrow, there is an 80% chance that the federal funds rate target will fall by at least 25 basis points. And today, the yield on 30 Year U.S. Treasuries increased by about 15 basis points nearing 4.6%. Suppose some combination of modest increases in long-term yields and one or two reductions of the federal funds rate target, we should expect uninversion of the yield curve to be just around the corner.