The Inverted Yield Curve Making Its Way To Australia
An inverted yield curve in the US is making headline news in financial circles. The reason for this is the history of inverted yield curves being a powerful predictor of recessions.
Inflation in the US has been at or below zero for short periods three times in the last 15 years. Most notably during the global financial crisis after the fall of Lehman Brothers. The most recent was at the beginning of Covid.
Before that, it had not been at zero for about 50 years.
The Australian data shows a different picture. The beginning of Covid also visited us with a zero-inflation rate. We also had zero inflation in the late 1990s and a near call during the recession we had to have. In another article, I have written about the prospects for inflation in the future.
Looking behind this data, we can see a feature that the US and Australia had in common, which was the long period of disinflation from about the early 1980s.
The Father Of Modern Day Central Bankers
This started with the period where Paul Volcker. He famously squeezed inflationary expectations out of the financial system. He did it brutally by engineering a recession. A strongly inverted yield curve was a signal for the recession to come.
It started a long period of growth in the US which began with ‘morning in America’. This period of growth spread around the world to other industrialised countries.
Along with the rise of the Chinese economy and its place as factory to the world, it set in motion a process of disinflation. We reached a stage where economists were becoming more worried about deflation setting in rather than any resurgence of inflation.
This process came to a shuddering halt with supply side difficulties bought on by Covid. The disruption to supply lines wrought by Covid and to the in energy prices caused by the Ukraine war combined to cause disarray in the global economy.
Transitory Inflation
These two factors represented big exogenous shocks to the economic order. They have caused a spike in inflation. They also set up disagreement among economists about how transitory inflation is.
The camp that argued that it would take a long period of high unemployment to remove inflation out of the system has so far been wrong. The winners in this argument are those who saw inflation as a transitory phenomenon.
It does not appear to have fuelled a wage-price spiral that would feed into future inflationary pressures. Instead, it has been driven by supply side issues that are being resolved and causing a drift downward in the level of inflation.
They centre a lot of these discussions on a particular notion. That if we can understand the behaviour of inflation and inflationary expectations, we can get a handle on the reaction of interest rates. The emergence of an inverted yield curve feeds into this discussion.
An additional factor has emerged regarding how interest rates are going to behave, which has also fed into the creation of the inverted yield curve. Interest rates are not just a policy tool. They are also price signals in the market for money.
We use interest rate policy as a method to manage activity in an economy by tempering overenthusiastic demand. This has been the primary determinant of interest rates for some time.
Interest rates have been close to zero as part of a policy response to various exogenous shocks. It has been easy to forget the major economic role that interest rates play in an economy.
The Loanable Funds Theory
Interest is the incentive required for savers who offer to lend their money. It is because they need to wait a period before they can get their original investment back.
Interest is the compensation paid to savers for waiting.
As ever, economists have a name for this. It is called the loanable funds theory.
Around the world, the demand for these savings has risen significantly. It is being driven by the activities of governments who are running the largest budget deficits for a long time.
To see where this way of looking at interest rate will take us, economists have come up with the notion of a theoretical interest rate. It is the rate which will prevail when an economy is at full strength and inflation is stable.
This rate is best considered in terms of when measuring deficits as a proportion of GDP.
Economists look at total debt as a proportion of GDP. It represents an important underlying relationship regarding its sustainability.
Interest Rate Versus the Growth Rate
Broadly, the relationship is this. If the real interest rate, that is nominal rates less the expected rate of inflation, is less than the economy’s growth rate, debt isn’t a burden. It is because the ratio of debt to GDP will fall. The burden becomes sustainable. In fact, debt is helpful.
Prior to Covid, the ratio of public debt to GDP in Australia was low relative to many other countries. This meant that even if we had the odd blow out in the growth of debt, there was space to accommodate this up to a point.
Our terms of trade also played a role in disguising any difficulties we may have with our servicing our debt.
Several things have happened that have altered that equation into a more uncertain direction.
The obvious one is the huge government expenditure that occurred because of Covid. The government stepped into support the economy when it was about to enter freefall. This was a sensible thing to do and played a large role in Australia reaching the level of full employment that we are enjoying.
The covid expenditure was a one-off expenditure and will eventually recede in significance.
The more critical Australian experience of the last few years is the persistence of large deficits, even when the economy is at full employment. It is largely a function of the strong safety net that Australia offers its citizens.
This safety net traditionally had a cyclical element to it, so that support for unemployment rose in periods of economic slowdown. The safety net now has a larger structural element to it. Introducing programs such as the NDIS whose costs are proving very difficult to contain, account for this.
In addition, the lack of reform to drive productivity; the erosion of flexibility in the labour market; and the guessing game involved with picking winners to become carbon neutral has meant the long-term growth of the economy has diminished.
This means that we have entered a period where the long-term interest rate has gone up around the world and in Australia. The demand placed on savings has driven up their cost.
Further, in Australia at least, the long-term growth rate has fallen because of two reasons. As well as sclerosis in our economy because of very low productivity, we have slowing demand because of high debt burdens. This high debt burden occurs in the private sector, which has traditionally had a high debt burden, and the public sector, which has not.
Getting finance to acquire a business in Australia is already difficult. Now that the private sector is being squeezed out, the situation may become worse. I have written about a solution to the lack of business finance for business sales in another article.
These things are causing an inverted yield curve in interest rates around the world.
The difference is that, with high levels of employment in Australia and the US, the inverted yield curve is not an indicator of a looming recession. It is an indicator of secular subpar growth.
