Why do yield curve inversions predict recessions (and why this time it might not)?

 

The brief inversion of the 2s-10s US yield curve led to a rather typical explosion of commentary discussing whether we are looking at a recession in the US in the next 6-18 months. This commentary is mostly based on the empirical evidence that yield curve inversions are the most reliable predictor or US recessions.[1] This raises the question ‘Why do yield curve inversions predict recessions?’.

Start with establishing what do yield curve inversions predict almost for sure: yield curve inversions are market-based predictions of future decrease in short term interest rates. Since yields of different maturity are equal to expected value of short term interest rates over the length of given maturity, then decreasing yield curve has to imply that market expects short term interest rates to be lower at some point in time in the future.[2]

With this established, the question then becomes why would an expected future decrease in interest rates be a predictor of a future recession. At a first glance, it seems obvious: recessions are associated with a decrease in interest rates. In modern economies this is because central banks decrease nominal interest rates to fight recessions; but even outside of modern economies, this should be the case, as recessions decrease demand for investment/consumption, and hence decrease the natural rate of interest.

However, this answer provides only a partial justification for why do yield curve inversions predict recessions. While expected future recessions should imply downward sloping yield curves, this does not mean that downward sloping yield curves necessarily imply recessions: necessary condition is not the same as a sufficient condition.[3] In other words, a future decline in interest rates does not necessarily mean a full recession, defined as outright decline in economic output. This is especially if one considers nominal interest rates in current environment: for example central banks in CEE have increased policy rates to extremely high levels to fight a bout of inflation, causing inversions in yield curves. However, local market yield curves are just predicting that interest rates decrease towards their long-run equilibrium values, and not below those values, consistent with central bank’s expectations that policy rates will be gradually normalized, reaching the long-run equilibrium levels from above. Therefore, an inversion is not signaling a recession.

The example of CEE countries holds a more general lesson: expected decrease in short term interest rates does not equal a recession, as short term interest rates can decrease outside of recessions. For example, central banks might orchestrate a yield curve inversions if they intentionally temporarily increase short term interest rates above their long-term equilibrium values. Or more generally, natural interest rates might decrease in absence of outright recession, in case of what is often called a growth recession: a temporary decline in the growth rate of the economy without an outright decline in output. A prime example was the 2019 inversion in yield curve, which was prompted by the economic slowdown caused by Trump’s trade war. While we will never know for sure, it is quite likely that if it was not for the pandemic, the US economy would experience just period of slower growth without an outright decline in output.

Turning to today, while there are good reasons to worry about recession in US, there is a good chance why yield curve inversion might not a be signal of one: the Fed is explicit that it wants to increase short term interest rates above the long-term equilibrium values. This alone should imply a yield curve inversion, but one intentionally engineered by the central bank. Of course, this policy might actually cause recession, which will then just add to the mythology surrounding yield curve inversions.

 

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[1] That said, theorical considerations also do play a role: one can construct models in which yield curve inversions cause, rather than just predict, recessions. I will ignore this aspect here.

[2] Strictly speaking, one could construct decreasing yield curve also by postulating term premium that decreases with maturity. While not impossible, especially in current environment with term premium compressed by regulatory requirements and large balance sheets of central banks, this seems to be rather an edge case. Moreover, argument carries less weight when one focuses on changes in yield curve slope, rather than just the arbitrary metric of negative-sloping yield curve: even if long-term yields are compressed due to compressed or even negative term premium, it should still hold that decrease in the slope of yield curve implies that short term rates are either expected to increase less, or to outright decrease. Similarly, the argument does not apply to the near-term yield curve spread, since there term premium plays limited role.

[3] Moreover, downward sloping yield curve is clearly not even a necessary condition: while one would generally expect downward sloping yield curve ahead of predictable recession, this of course does not apply to unpredictable recessions, and most recessions are thought to be unpredictable. Case in point was the pandemic recession, which was clearly unpredictable 6-12 months ahead of time. From this perspective, it actually seems odd that yield curve inversions are such a reliable predictor of recessions: it is as if something that is thought to be mostly unpredictable is being reliably predicted.

Does inflation cause decrease in aggregate demand?

With inflation occupying the headlines, one can often read arguments that high inflation will cause a decrease in the aggregate demand and potentially a recession. What does basic macroeconomics have to say about this argument? The simple answer is that such reasoning is faulty, but the more complicated answer is that in current situation it might hold a grain of truth.

Start with the basic AS-AD model, which has the total output on the horizontal axis and the price level on the vertical one.[1] In this space, the aggregate demand is a downward sloping curve, with higher price level resulting in lower total output demanded. Meanwhile, the aggregate supply is upward sloping curve, capturing that higher price level means higher total output supplied.

On the first (very brief) look it might seem that inflation can indeed cause decrease in aggregate demand, but one should quickly realize that this reasoning is faulty: while the total output demanded will decrease when price level increases, the curve capturing the relationship between output demanded and price level is the same. In other words, this is a macroeconomic analogy of the mistake made by first year students of microeconomics, who struggle to distinguish between decrease in quantity demanded caused by higher price, and decrease in demand caused by some other factor. Since only the change in (aggregate) demand or supply can change the equilibrium price (level), then arguing that higher price (level) leads to lower (aggregate) demand is confusing causes with consequences: the price (level) is an equilibrium outcome of the model, and not a driving force of changes in the equilibrium. As one of my favorite bloggers says, an economist should never argue from a price change!

At this point one could feel that this is just semantics – economists often say that higher price means lower demand, knowing full well that it is really quantity demanded what they have in mind. They do this because they speak to general population that did not go through basis economic course and hence would not understand the terminology of “change in quantity demanded” vs. “change in demand”.

However, the problem is that in many situations the writers are not using this as a shorthand terminology, which then leads to problematic lines of reasoning. In case of inflation and aggregate demand, the problematic reasoning goes like this: we are currently seeing high inflation, which will cause a decrease in aggregate demand, and hence we are in danger of economy going into recession.

In this reasoning, the high inflation is what is driving the economy into recession. This reasoning is problematic because high inflation is a response of the model to some shock, not source of shock. To see this consider a scenario in which current inflation is caused by large increase in aggregate demand. In such situation, the AS-AD model tells us that output should increase and so should price level, both of which we observed. Is there a reason to worry about decreasing aggregate demand and recession? No, because we started with increase in aggregate demand!

What about the situation when the higher prices are cause by decrease in aggregate supply, say because of an supply bottlenecks? Here, we will indeed observe decrease in output – a recession – and inflation. However, it is not inflation causing the decline in output, it is the supply shock and corresponding decrease in supply. Worrying about inflation is double-counting: there is no further decrease in output because of the high inflation, all of the decrease is due to the supply shock.

The faulty reasoning can go even one step further: if inflation will cause decrease in aggregate demand, then, some argue, this is all good, because lower aggregate demand will lead to lower prices/inflation, which is what we need. Of course, one then can wonder whether lower prices will not cause higher aggregate demand, which will cause higher inflation… and so on and so on.[2]^,[3]

Overall, we are left with the conclusion that in basic macro saying “inflation will cause decrease in aggregate demand” is a nonsense. Does it mean the argument belongs to garbage bin? Or could we find support for it if we leave the world of basic macro? Every now and then I catch myself being annoyed with some argument which is a bad economics, but that captures some more complicated story that is valid, and I think this is the case here.

To see this, consider abandoning the notion of homogenous output, and considering heterogenous outputs. Large part of the European inflation right now is driven by jump in energy costs, reflecting the combination of diminished supply and revived (global) demand. While the diminished supply in AS-AD world would amount to concurrent decrease in aggregate supply and increase in aggregate demand, resulting in inflation, the AS-AD world is maybe not very suitable for the present situation. Instead, we could think about things in terms economy with two sectors, energy sector and all the rest, and assume that energy is supplied by foreign country. In such situation, increase in price of energy will lead to a decrease in aggregate demand in the rest of the economy, and hence inflation will indeed cause something which is akin to decrease in aggregate demand.

What about savings, not present in basic static macroeconomics, could those create link between inflation and aggregate demand? Inflation clearly leads to decrease in value of savings, so it might seem that inflation will cause decrease in savings, which will cause decrease in aggregate demand. However, this story is not fully satisfying from macroeconomic perspective: in general, higher prices also mean higher profits and higher wages, which should cancel the effect on aggregate demand. But it might be the case that the higher prices are indeed driving decrease in aggregate demand, if we either consider heterogeneity of households or some form of myopic behavior. In case of heterogenous households, it might be that the distribution of costs of higher prices and benefits of higher prices is such that it shifts money towards households who will spend less. In case of myopic households, it might be that higher households are spending for as long as they have money in their accounts, but once they draw down these balances, they stop spending.

So, there, we have it. In general, the argument “inflation will cause decrease in aggregate demand” rings hollow, but it might not be always the case if the inflation is either heterogenous in terms of its source, coming from decrease in supply in particular sector of the economy, or heterogenous in terms of distribution of impacts on households. I don’t think that’s what the pundits have in mind, though.

P.S.: Note the microeconomics equivalent of this blogpost is a blogpost about “Do higher car prices cause lower demand for cars?”. The answer is yes, if one means decrease in quantity demanded, but no, if one means that people will not want to buy cars anymore and that car makers should be worried: as soon as price of cars will go back down, quantity demanded will again increase.

 

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[1] One could re-formulate the model so that we have (surprise) inflation on the horizontal axis instead of price level.

[2] The is again analogical to microeconomics, where you will see students in an endless loop of reasoning: higher price means lower demand, which means lower price, which means higher demand, which mean higher price, which means lower demand, …

[3] This last point points towards a way one could salvage the argument that inflation will lead to decrease in aggregate demand. Maybe, it could be an argument about disequilibrium and dynamics. Maybe, the decrease in aggregate supply was not matched by decrease in aggregate output demanded yet, and hence decrease in output is to be expected in due course. It does not take the form of shift in the curve, but rather movement from disequilibrium position to position back on the curve.

However, this does not solve the puzzle fully: the already observed higher prices mean that we have moved, so current inflation should not cause further decline in output demanded in future. Moreover, in economics it is typically the prices that adjust faster than quantities. After all, the decrease in supply means that we are not able to produce the same quantities as before, so it is hard to see how it is the prices that adjusted first and quantities will adjust later.

Reminder: Price setting is a coordination game

 Inflation is the main topic of macro discussion right now, with price increases exceeding expectations, even after accounting for the additional shocks. As usual, the media focus is on the situation in the U.S., but the phenomenon is pretty much global This means that other countries can offer us some clues on the nature of the phenomenon.

One such country is Czechia, which combines features that make it an interesting learning case. On one hand it is a country with firmly established inflation targeting, so that it is not plagued by the regular instability of inflation expectations that haunt many emerging markets. This means that its experience is relevant for central banks in developed economies, unlike experience in, say, Brazil or Turkey. On the other hand, it is a small open economy with significant focus on industrial production. This means that its experience is not only sufficiently different from US or euro zone, but that it is more exposed to current sources of inflationary pressures than these countries.

So what is the recent inflationary development in Czechia? Simply, inflation is running amok: prices have increased by around 1% in each of the last 4 months. That is,  increase of 4% in span 4 month. Or to put in yet another way, it is the increase central bank desires in a two-year period occurring in four months. While the sources are to some degree global, such large increase cannot be explained by these factors alone. And before one jumps into conclusion that this is result of domestic policy mismanagement, it is important to note that the government support for the economy was not abnormal – apart from decrease in income tax benefiting mostly the rich – and that the economy is actually doing quite badly relative to its peers.

So what is the lesson here? This is speculative, but one way to think about the situation is in terms of what we know about the incentives for price setting. Increasing prices is in its nature a coordination game: each firm does not want to raise its prices in order not to lose customers to its competitors. This is what lies behind sluggishness of price adjustment in economic models.

But what if everybody knows that everybody will be increasing prices because of spike in input prices such as commodity prices, energy prices, component prices etc.? Well, if price setters know that their competitors will be increasing prices now, and that they will need to increases prices relatively soon anyways, then they might as well decide to increase prices right away. After all, higher prices are less likely to be noticed in environment when everybody is increasing prices.

This means that the rapid price growth might be result of coordinated equilibrium: everybody increasing prices because they observed public signal that everybody will be increasing prices. And as such, some of the price increases we are seeing might be prices increases brought forward, causing inflation to spike more than one would expect. In other words, we might be seeing a year worth of price increases crammed into several month in which everybody expected everybody to hike prices.

This means two things. First, in the short term inflation is likely to surprise on the upside even more, with other price setters jumping on the inflationary bandwagon. Second, the inflation might drop relatively quickly: once the period of rapid price increases is over, further price increases might not be forthcoming, since they have been brought forward. In some sense, we will have reached the natural level of prices, just in different path, with rapid inflation followed by quick slowdown in inflation, rather than gradual rise we are used to. Of course, the second observation applies only if the inflation does not cause change in inflation expectations, in which case rapid inflation could start to feed on itself.

 

This pattern might even fit the historical experience: it seems that commodity-driven inflationary periods which did not result in shift in inflation expectations are often followed by long periods of subdued inflation. Most recent example is the example of inflationary spike in 2011, and long years of low inflation afterwards.

 

P.S.: Note that this is one example of why the Calvo pricing is so not up to the task: it does not allow firms to choose when to change their prices, only by how much, and hence does not allow for coordinate price increases.

P.P.S.: In terms of time series modelling, this would suggest that the price level, not just its part rate of change, is important. Or alternatively, that there are more regimes in inflation.

P.P.P.S.: There is a notion of attention-driven inflationary behavior in here: maybe individual price rises are less likely to be noticed when they are done in environment of many prices rising.