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Thursday, April 19, 2018

FIFO Monetary Policy and the Business Cycle

With all the talk of Yield Curve flattening and recession forecasting in the U.S., see U.S. Yield Curve and Risk of a Liquidity Trap ; it occurred to me to consider the interest rate structure of other developed economies and also juxtapose the economic narratives. Developed economies are generally experiencing low unemployment rates paired with low wage growth, healthy housing markets paired with available credit, and overpriced equity markets paired with geo-political uncertainty.

The common theme of shrinking spreads between long-term interest rates and short-term interest rates suggests that many developed economies are on similar positions on their business cycle. It stands to reason as Central Banks synchronized their response to the Great Recession, and monetary policy accommodation during the recovery and expansion stages of the business cycle. When the Federal Reserve embarked on its current monetary policy tightening cycle, they all but ensured that the U.S. economy would once again lead the world economy into its next recessionary cycle and out the other side.

By tightening monetary policy, which is inherently short-term, the Federal Reserve is accelerating the pace of yield curve flattening. As they drain liquidity from financial markets by selling short-term bonds, the Fed pushes up short-term interest rates. The loss of liquidity means less money is available to keep pushing up the price of equities so stock markets fall too. And finally, as stock prices fall investors buy long-term bonds for safety, pushing prices up and long-term interest rates down. This shift represents a change in market participants expectations about the trend in economic growth over the duration of the yield curve. Long-term rates falling relative to short-term rates is interpreted as future growth is expected to fall.

Central Bank policy and crisis response is generally backward-looking, so they only respond to  recession after it is underway even if they are the technical cause. That being said, the first economy to go into a recession will have its Central Bank modify policy, and will be the first to cycle out of recession and onto recovery and expansion. First In First Out (FIFO).

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