Michael J. Dueker

English

Research Papers in Economics

May 1998
MonetaryTrends
Inverted Yield Curves
and Recessions
As forward-looking institutions, credit markets
often provide useful glimpses of future economic
developments.  The spread between long-term and
short-term interest rates (called the slope of the yield
curve) has garnered particular attention as an indica-
tor of recessions.  The accompanying chart shows
that short-term rates (e.g., the rate on 3-month
Eurodollar deposits) exceeded long-term rates, that is,
the yield curve became inverted, prior to each of the
recessions since 1972.  Should we worry today about
the possibility of a recession because of a yield curve
that recently has flattened and may yet invert?
Past yield-curve inversions resulted from sharp
increases in short-term rates that coincided with
surges in inflation.  In 1974, 1980 and 1981,
upswings in short-term interest rates boosted them
above long-term interest rates by several hundred
basis points.  A marked inversion of the yield curve
is, to some extent, a passive indicator of coming
weakness in the economy, but also directly curtails
economic activity through a bank lending channel.
Because bank deposits generally are shorter in matu-
rity than bank loans, inversions of the yield curve can
squeeze bank profit margins and discourage new
lending.  When interest rates on bank deposits had
legal ceilings prior to the mid-1980s, periods of high
short-term interest rates led to disintermediation and a
shortage of loanable funds in the banking system.
Recently, the yield-curve slope has decreased
because of falling long-term rates, rather than rising
short-term rates.  If short-term rates remain fairly
steady in the near term, it is highly unlikely that long-
term rates would fall enough to cause more than a
mild inversion of the yield curve.  Yet, is there a dan-
ger that even a mild inversion of the yield curve
could foreshadow a recession, as in 1989?  Possibly
not, because two special factors pervaded the 1990-91
recession.  First, the 1986 Tax Act removed in phases
key tax breaks for commercial real estate that had
been instituted only a few years earlier.  This whip-
sawing in tax treatment caused an overbuilding fol-
lowed by a severe downturn in the market for com-
mercial real estate, which negatively impacted bank
balance sheets.  Second, base closings and other cut-
backs in defense spending caused downturns in areas
of the country that had remained largely immune to
recessions for most of the Cold-War era.  Today,
American businesses, especially banks, have stronger
balance sheets than in 1989.  Hence, if the yield curve
were to become mildly inverted today, the business-
cycle effect probably would be minor.  Moreover, a
slight, temporary inversion of the yield curve could
well reflect a positive long-run development:  a
permanent disinflation.
￿Michael J. Dueker
Views expressed do not necessarily reflect official positions of the Federal Reserve System.
Lending Growth
(Loans and Leases)
72 74 76 78 80 82 84 86 88 90 92 94 96 98
-5
0
5
10
15
20
10 Yr. Govt. Security
Constant Maturity
CPI
Inflation
3-Mo. Eurodollar
Deposit Rate
The Yield Curve, Inflation, and Bank Lending Growth

Inverted yield curves and recessions

http://research.stlouisfed.org/publications/mt/19980501/cover.pdf

Inverted yield curves and recessions

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Research Papers in Economics