Some Federal Reserve officials are saying it is too soon to consider cutting U.S. interest rates, despite rising market speculation of such a move because of slowing global growth.
A recent development in the bond market shows investors expect the Fed is done raising rates and increasingly expect officials could lower them.
The development, called a yield curve inversion, occurs when the yields on long-term Treasurys fall below those of short-term government securities, a reversal of the norm.
Before considering whether to lower rates, “I’d need to see an inversion of some magnitude and/or some duration, and right now we don’t have either,” said Dallas Fed President Robert Kaplan in an interview.
Yields on 10-year Treasury notes fell below yields on three-month Treasury bills last week for the first time since August 2007 after a spate of weak manufacturing data from Europe.
To show persistence, a yield-curve inversion would need to last for months and not weeks, Mr. Kaplan said. “If you see an inversion that goes on for several months…that’s a different kettle of fish,” he said. “We’re not there yet.”
Inverted yield curves have typically preceded a recession by one or two years, but they aren’t necessarily a recession indicator. Instead, the yield curve inverts when markets expect the Fed’s next move is to cut rather than raise rates.
Mr. Kaplan was one of a handful of Fed officials who said last year they wouldn’t want to lift short-term rates above long-term rates to invert the yield curve.
The recent yield-curve inversion reflects bond investors’ expectations of slower-than-anticipated economic growth, Mr. Kaplan said, adding it was too soon to say whether investors would be right. “I’d be careful not to over-read or overreact in any moment to what markets are saying…because they have the ability to change on a dime,” he said.
Chicago Fed President Charles Evans on Monday highlighted the potential for the central bank to cut rates if the economic growth deteriorated more than Fed officials anticipate.
Fed officials held their benchmark rate steady last week and lowered their growth forecasts slightly; most didn’t think the Fed would need to adjust rates at all this year.
At a speech in Hong Kong, Mr. Evans emphasized one historical episode in which the Fed had taken out an insurance policy that helped avoid recession. In late 1997, policy makers had adopted a “cautious wait-and-see posture,” even though many had expected they would need to raise interest rates.
“Sound familiar?” Mr. Evans said, noting the similarity to the Fed’s recent move to put rate increases on hold.
He then reviewed the Fed’s decision to cut its benchmark rate three times over two months in late 1998 during an international financial crisis. “How did this risk-management strategy turn out? In the end, the economy weathered the situation well,” Mr. Evans said.
At his news conference last week, Fed Chairman Jerome Powell played down concerns that a tech-stock bubble that followed the 1998 rate cuts might foreshadow similar risks for asset markets in easing monetary policy now.
“We’re in a very different world today,” Mr. Powell said. “We don’t see financial stability vulnerabilities as high.”
Economists and Fed officials have also drawn attention in recent days to unique factors that could make the yield-curve picture more dramatic compared with prior inversions.
At issue is the so-called term premium, or the extra yield investors demand for holding a longer-term security. Global central bank asset purchases in recent years have lowered such term premiums.
The upshot is that while rates implied by futures markets show investors expect the Fed to cut rates over the next two years, these projected cuts disappear after accounting for a term premium that is currently negative, said Roberto Perli, a founding partner of Cornerstone Macro, in a note to clients on Tuesday.
After adjusting for this term premium, market expectations largely match the recent rate projections from Fed officials, he said. Most officials expect to hold rates steady this year before possibly raising them once next year.
“I’m not freaked out” by the yield curve inversion, and “hopefully businesses and market participants won’t freak out” either, said San Francisco Fed President Mary Daly in a speech Tuesday.
Mr. Kaplan said he didn’t want to speculate on the Fed’s next move until seeing potentially several more months of economic data, particularly because he attributes weak first-quarter economic activity partly to the 35-day partial government shutdown that began in December and ended in January.
“I’m being very careful not to speculate on what we do next,” he said. “I don’t think we’re going to have a good fix on that until we get a better grip on the second quarter, because the first quarter is very noisy.”
He said he estimates the Fed’s benchmark rate, currently in a range between 2.25% and 2.5%, is close to a neutral setting designed to neither spur nor slow growth. “I doubt we’re accommodative, but I also doubt we’re restrictive,” said Mr. Kaplan. “If we’re restrictive, it is very modest.”
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