Flat yield curve? Not to worry, Fed policymakers say

By Tom Polansek and Ann Saphir

CHICAGO/SAN FRANCISCO (Reuters) – As the gap between short- and long-term borrowing costs hovers near its lowest in 10 years, some investors worry the so-called yield curve is flashing red: that a recession, always preceded by such a flattening, could be around the corner.

Not to worry, two Federal Reserve policymakers said on Friday; the curve will likely steepen as the U.S. government runs a bigger deficit and issues more debt, they said. And anyhow, growth prospects ahead look pretty strong, which is why the Fed is raising short-term interest-rates.

Those rate hikes, they said, are in and of themselves acting to narrow the gap between short- and long-term rates.

The comments, from the New York Fed’s incoming chief and from Chicago Fed chief Charles Evans in back-to-back but separate appearances, appeared calculated to allay concern about a potential recession.

“The yield curve is not nearly as much of a concern as I might have pointed to a couple months ago,” Evans said in Chicago after a speech, in response to a reporter’s question.

Williams, who will leave his current job as San Francisco Fed President in June to take over at the New York Fed, also said he is not so worried about the flat yield curve and expects it to steepen somewhat. The Fed’s gradual slimming of its $4 trillion-plus balance sheet will also put upward pressure on longer-term rates, he said.

In January the U.S. Congress passed a budget deal that boosts U.S. government spending, following a December tax package that slashes corporate tax rates. Both changes are expected to lead to an increase in government borrowing in coming years. The Fed policymakers reason that a bigger supply of debt should put downward pressure on Treasury prices, and deliver a corresponding lift to yields.

“We’ve got more fiscal debt in train in the U.S. That has to be funded,” and will likely push up long rates and steepen the yield curve, Evans said.

Though Evans has long been a dove, advocating for low rates to boost employment and inflation, recent fiscal stimulus and signs of stronger U.S. economic growth have shifted his views of late. On Friday he said he supports continued gradual rate hikes amid a stronger economic outlook.

That view puts him more in line with Williams and the center of the Fed policy-setting committee, which sees two or three more rate hikes this year and more next year.

Dallas Fed President Robert Kaplan earlier this week, though, signaled he was not as sanguine about the yield curve, and suggested he might want to slow or stop raising rates if longer-term yields do not rise further.

“The flat yield curve tells me the bond market sees sluggish economic growth in the medium term and I for one do not want to be in the position of raising the fed funds rate and creating an inverted yield curve,” he said in Miami. An inverted yield curve, where short-term rates are above long-term rates, has preceded every recent U.S. recession.

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