As the current economic expansion nears record length, observes more frequently publish lists pf “risks” that could precipitate a recession and an end to the expansion: weak global growth, China, the “black swan event” du jour, a Federal Reserve policy error, fiscal insanity, and the old inverted yield curve.  Pick your favorite interest rates (or ones that fit your story) and within 20 months or so (almost 2 years) of an inversion, a recession will allegedly start.  Inverted yield curves don’t “cause” recessions, they simply signal imbalances, however created, in financial markets and consequently in real markets.  Expectations matter: if we expect a recession and adjust our behavior accordingly, we’ll get a recession or slowdown.

Apparently, liquidity is like toothpaste: once you squeeze it out, you can’t put it back.  So out global central banks squeezed the tube and bought every risk-free asset they could find.  The Fed bought $4 trillion of them to provide liquidity, and in the process, interest rates headed toward 0. It was assumed that once the economy started growing, those assets would be returned (sold) to the private sector and the liquidity extinguished.

As the Fed started rising rates and reducing its bond holdings, a funny thing happened on the way to “normal.”  Financial markets ground and politicians, wanting a strong economy (i.e. a strong stock market) in 2020 for the elections, began to complain.  The Fed took cues from the stock market and shifted in neutral.  It abandoned its “plan” to continue to raise rates and move further away from 0, reverting back to “data dependency,” e.g. monthly monetary policy.  The Fed’s “plan” seems to be watch the data, them, are a policy change.  This rate change has no immediate effect on the real economy because according to past research, there are long lags between interest rate changes and changes in real economic activity (e.g. business investment, etc.). Financial markets however respond immediately, looking at the data that it expects the Fed will respond to. This will continue to drive monetary policy choices because there is no other road map for policy that looks to the future, just pressure to maintain asset prices.  Stock markets are at a record high levels, and the Fed appears afraid to do anything that might change that.

This is the position that all central banks in market economics now find themselves in.  They can’t reduce bond holdings because that raises rates becuase, well, that raises rates too, and financial markets don’t like it.  After all, raising short rates invites the much feared “inversion.” The economy is at full employment, and labor is in short supply.  Yet, the real wish-free of interest, a proxy for the return on capital, is well under 1% and saving for retirement is difficult with a 2.5% yield on the 10-year Treasury bond (which is held down by central bank hoarding of risk-free assets).

The Fed has squeezed itself into a corner.  When the economy slows, the Fed will have little room to cut rates (historically cutting 4 to 5 percentage points), but it will start buying bonds (QE again) hoping liquidity and lower rates will help even though they didn’t do much last time (round one excepted).  The Fed will add a few trillion to its balance sheet and, when the recession/slow period ends, it will have $8 trillion in riskless assets instead of $4 trillion.  The private sect demand for these rich free assets will keep rates low as central banks hoard them.  Maintaining that level as bonds mature will require major Fed excursions into bond markets.

Traders win, savers lose.  Interest rates, one of the most important prices in a market economy, allocating capital to highlight values uses, will be crippled as they were starting in 2009, and economic growth will pay a heavy price for this intrusion into private markets.