Bernanke warns against reading wrong yield curve signal

Distortions mean an inversion does not necessarily point to recession, says former Fed chief

Gillian Tett and Joe Rennison in New York


The last time the yield curve inverted was at the start of 2006, just as Ben Bernanke began leading the Fed © Bloomberg


It would be a mistake to think that the unexpected flattening of the US yield curve signals a looming recession, Ben Bernanke, the former chairman of the Federal Reserve has warned.

Mr Bernanke’s comments come as Fed officials under Jay Powell debate the significance of the narrowing gap between short- and long-term bond yields — a measure of the yield curve.

An inversion of the curve, where short-dated interest rates rise above longer-dated rates, is seen as a warning sign for recession, having preceded every economic downturn of the past 50 years — but some officials believe it has lost its signalling power because of market distortions caused by central banks.

“Historically the inversion of the yield curve has been a good [sign] of economic downturns [but] this time it may not,” because the normal market signals have been distorted by, “regulatory changes and quantitative easing in other jurisdictions”, he said, speaking with former treasury secretaries Hank Paulson and Timothy Geithner at an event to discuss lessons from the 2008 financial crisis.

“Everything we see in terms of the near-term outlook for the economy is quite strong,” he added.

Short-dated Treasury yields have been pushed higher as the Fed has raised interest rates. Meanwhile, longer-dated interest rates have not risen as quickly. Neel Kashkari, president of the Federal Reserve Bank of Minneapolis, said on Monday that the Fed should stop raising rates to avoid inverting the yield curve and risking economic turmoil, echoing some investors’ fears.

The last time the yield curve inverted was at the start of 2006, just as Mr Bernanke took office as Fed chair. The Fed continued raising interest rates until June that year. Rates were kept unchanged until September 2007, when it began to cut them again as economic conditions worsened.

But many now argue that the flat yield curve shows the system remains heavily distorted by the unprecedented central bank bond-buying programmes implemented after the financial crisis — meaning central bankers face a long path to return the system to normality.

Mr Bernanke himself did not comment on how badly distorted the financial system might currently be. However, he warned investors that they should not presume that the Fed’s balance sheet would shrink much further in the coming years.

Before the crisis the Fed held less than $1tn of assets, but this quadrupled during the crisis, before the Fed started recently cutting back. “We are not going anywhere close to $800bn again — I think the normal level of the Fed balance sheet is [going to be] closer to $3tn.”

Separately, Mr Bernanke, Mr Paulson and Mr Geithner declared that the US financial system was more robust than now than before the crisis, because of regulatory changes. But they expressed concern about the slow pace of action in Europe, which remains plagued by concerns about the health of some banks, ranging from small Italian lenders to large entities such as Deutsche Bank.

“[The Europeans] kidded themselves about how well capitalised their banks were for a long time,” Mr Paulson said. “I do believe that they have been slower to do the things they need to do.”

They also voiced fears that after the crisis Congress removed many of the statutory powers which Fed and Treasury officials had used in 2008 and 2009 to quell the financial panic.

“You have a more stable [financial] system today because the defences are better — but you have a weaker set of tools for dealing with an extreme crisis,” Mr Geithner said, noting that the 2008 crisis showed “how dangerous it is to not have tools”.

Mr Bernanke and Mr Paulson also pointed to the expansion of US government borrowing.

“This is the most predictable financial crisis in the world,” said Mr Paulson. “Do I think there will be a panic anytime soon? No. But the longer we wait [to deal with it] the more expensive it will be . . . when the economy is so strong is precisely the time the US government should be making an effort to deal with our fiscal issues.”

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