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Fed Policies Perhaps Driving Us Towards Recession

May 21, 2018

|Daniel A. White

Did the Federal Reserve make a policy mistake by tightening liquidity and raising rates?

JP Morgan analysis points to “yes,” and suggests a recession could be around the corner without a change of course. The firm also says the Fed’s model isn’t picking up the danger signs.

Evidence lies in the jobs and manufacturing data, which suggest a production slowdown.

We added only 103,000 jobs in March. A prominent manufacturing production index that measures raw material orders dropped to a global 14-month low.

And the “Nowcast,” a measure of global growth, slid nearly a whole point in early 2018.

But the key measure JP Morgan highlights is a one-month overnight index swap (OIS) that tracks central bank lending rates and serves as a good proxy for the Fed’s policy rate.

That rate has flattened and inverted two years too early.

By now you must be asking – what does this all mean?

Well, the early inversion is a rare occurrence, happening only three times in the past 20 years. And it usually means a recession ahead.

The first time was in 1998, but Fed Chairman Alan Greenspan flooded the financial system with liquidity and avoided economic calamity.

When it happened in 2000, recession was clearly ahead of us.

And in 2005, it was the signal that the U.S. housing boom was turning to a bust.

The problem is, the Fed’s measure is different. It looks at the 10-year and 2-year Treasury yields. When the 10-year dips below the 2-year, there are problems on the horizon.

However, that hasn’t happened yet. And looking back, it tends to happen months after the OIS signals. By then, it’s too late.

Stay tuned. We’ll soon find out if the Fed’s liquidity and interest rate policies will help or hinder.

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