Inverted Yield Curve Doesn’t Cause Recessions, But It Predicts Them

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Source: AP Photo/Seth Wenig

One of the big financial news stories of the past month has been the inverted yield curve, which means that the interest rate on long-term government debt is lower than that on short-term debt. During expansions, interest on short-term government debt is lower than long-term. In other words, things are upside down. Inverted yield curves are rare events and often predict a recession within two years, although a couple of recessions have happened without the curve inverting.

John Tamny recently chastised market pundits for claiming that the Fed’s monetary policy is too tight and caused the inverted yield curve. The writers and talking heads who make that claim are followers of a school of macroeconomics known as monetarism. Milton Friedman was a famous monetarist. Monetarists believe that monetary policy drives everything. They have no objective measure of “tight” or “loose” monetary policy. Policy is too tight if the economy is slowing and too loose if inflation gets out of control.

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