The Federal Reserve has existed for 105-years; it was founded in 1913. The Fed prides itself on economic forecasting, which it uses for purposes of setting monetary policy.
The U.S. has had 19 recessions since the Fed was created and the Fed has predicted none of them. That’s right. With all of its forecasting machinery, the Fed is 0-for-19 when it comes to predicting recessions.
There are reasons for this. One reason is political. If the Fed saw a recession coming, there would be a strong argument for easing monetary policy. But, the Fed often has its own reasons for tightening monetary policy having to do with inflation or currency wars, so it avoids a forecast that would cause it to reverse policy.
The Fed also uses badly flawed equilibrium models (the economy is not an equilibrium system) so it simply misses the warning signs.
Finally, the Fed likes to keep its head down when it comes to political debates. Avoiding recession calls helps the Fed to avoid blame when the recession actually does arrive. That’s why this article is so extraordinary.
Two staff researchers from the San Francisco Fed have published a study warning that a recession may be coming and the Fed should reconsider its policy of raising interest rates, at least for the time being. The researchers use the flattening of the yield curve as their leading indicator.
Generally the yield curve (which shows interest rates across various maturities) is upwardly sloping from left to right. That makes sense because investors want higher rates for longer maturities because they take more risk. When the yield curve flattens or slopes downward, it means investors are worried about inflation in the short-run and declining rates due to recession in the longer-run.
It’s a very reliable warning of recession and it’s what the Fed researchers are seeing now. The good news is that the Fed may finally get a recession call right. The bad news is that the Fed governors in Washington are not listening.
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