Not only do we have an 4/6  BIS central bankers' speeches  economy that is growing at an above-trend pace—at a time when the labor market is already quite tight—but the economy will be getting an extra boost in 2018 and 2019 from the recently enacted tax legislation. Moreover, even though the FOMC has raised its target range for the federal funds rate by 125 basis points over the past two years, financial conditions today are easier than when we started to remove monetary policy accommodation. This suggests that the Federal Reserve may have to press harder on the brakes at some point over the next few years. If that happens, the risk of a hard landing will increase. Historically, the Federal Reserve has found it difficult to achieve a soft landing—especially when the unemployment rate has fallen below the rate consistent with stable inflation. In those circumstances, the Federal Reserve has been unable to both push up the unemployment rate slightly to a level that is consistent with stable inflation and avoid recession.8 Now, I don’t want to imply that a recession is inevitable once the FOMC finds it necessary to nudge up the unemployment rate to a sustainable level. The starting point in terms of the inflation rate is also important because it will influence how far the FOMC is likely to go in terms of making monetary policy tight. Nevertheless, I think it is fair to say that the track record on this score is not encouraging.
Not only are bond term premia depressed due to quantitative easing both here and abroad, but the low inflation environment is also likely a contributing factor. If investors perceive that the risk of significantly higher inflation has fallen over time as inflation has persistently undershot 2 percent, they should demand lower bond term premia as compensation for inflation risk. Finally, while inverted yield curves have typically preceded recessions, I am unaware of any causal element in that relationship. For example, I don’t believe that banks become unwilling to lend when the yield curve inverts and that this tightening of credit availability “causes” a recession. I think it is noteworthy that in the current environment, higher short-term interest rates tend to raise—not lower—the banking industry’s profitability. This is demonstrated, in part, by the strong performance of bank stocks in 2017 as the Federal Reserve raised short-term interest rates. As I see it, the Treasury yield curve becomes inverted when investors believe that short-term real interest rates are high and monetary policy is tight. Investors anticipate that such a regime will slow the economy and be followed by a reduction in short-term rates. Because these expectations turn out to be validated eventually, we observe that inverted yield curves precede and signal recessions. But, we are not in this situation currently. Investors expect short-term interest rates to rise, not drop, and to remain higher in the future than they are now. Despite the flatter yield curve, the consensus view continues to be that monetary policy is not yet tight.