Minneapolis Fed President Neel Kashkari on Monday joined the latest debate raging among economists: Should people be worried that a reliable indicator of previous recessions is getting close to warning of a new one?
Kashkari said yes.
In an essay published Monday morning, Kashkari added the bond market to the list of reasons he has resisted raising interest rates during his year as a voting member of the Federal Reserve’s rate-setting Open Market Committee.
“The bond market is telling us that the odds of a recession are increasing and that inflation and interest rates will likely be low in the future,” Kashkari said. “These signals should caution the FOMC against further rate increases until it becomes clear that inflation is actually picking up.”
Kashkari was consistently the most dovish member of the committee this year, at times voting alone against a rate hike. The committee raised rates three times, by a quarter point each time, to 1.5 percent in the latest move last Wednesday. In that vote, Kashkari was joined in dissent by Chicago Fed President Charles Evans.
Presidents of the regional Fed banks rotate voting service on the committee. While Kashkari will remain an observer to the committee, he will not be a voting member again until 2020.
His departure as a voter is part of a bigger change at the committee. Evans and Dallas Fed’s Robert Kaplan, who expressed worry about the bond market a few weeks ago, are also leaving as voting members. And Fed Chairwoman Janet Yellen, who has been more hawkish, is being succeeded by Jerome Powell, a Fed governor who has said he expects gradual increases in interest rates to continue.
In resisting rate increases throughout the year, Kashkari expressed worry that the U.S. job market is not as strong as the unemployment rate suggests. He has looked for stronger wage growth and a higher participation rate in the labor force.
Kashkari has also consistently noted the defiantly low rate of inflation, which remains below the Fed committee’s target rate of 2 percent and has actually gotten lower this year.
On top of the still-slack job market and low inflation rate, Kashkari says the bond market is flashing a signal of a higher risk of recession.
The so-called yield curve spread, which is the difference between the yields of 10-year and 2-year U.S. Treasuries, has dropped from 1.45 percent two years ago before the Fed started raising interest rates to .51 percent today.
When the 2-year rate yields more than the 10-year, the spread turns negative and the curve inverts. That condition has preceded every U.S. recession for the last five decades.
Other economists and investors in recent months have talked about the flattening of the yield curve.
After last Wednesday’s meeting, Yellen said, “There is a strong correlation historically between yield curve inversions and recessions. But let me emphasize that correlation is not causation, and I think that there are good reasons to think that the relationship between the slope of the yield curve and the business cycle may have changed.”
Yellen said investors were not expressing concern about the flattening yield curve.
She said they see the odds of a recession as low “and I’d concur with that judgment.”
But Kashkari said that raising rates could help push the country into recession.
Short-term rate rises are pushing up short-dated yields, such as the 2-year and 5-year Treasuries.
Meanwhile, the hawkish policy sends a signal to investors that inflation will stay low for a long time, which suppresses long-dated yields.
“These signals should offer caution about future federal funds rate increases, unless inflation picks up,” Kashkari wrote.
He said it is perplexing that unemployment has moved steadily down to 4.1 percent while wage growth and inflation have been “muted.”
“In my view, the two most likely explanations are that the job market is not as tight as the 4.1 percent unemployment rate suggests and that people’s expectations for future inflation have fallen, which can become self-fulfilling,” Kashkari wrote.
While the idea that inflation should be higher is perplexing to many people, Kashkari pointed out that there is a danger to inflation that is too low.
One is that people who expect inflation to be low do not press their employers for higher wages.
Another is that a central bank is better equipped to fight a recession when inflation is high than low.
“From a risk management perspective, we have stronger tools to deal with high inflation than low inflation,” Kashkari wrote. “Looking at all these factors together led me to vote against a rate increase.”