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Virtually No Inflationary Pressure
By Mel Miller

Third in a series of economic updates focused on key economic indicators.

The Federal Reserve has a dual mandate: To maximize employment while maintaining stable prices.

This dual mandate often creates conflict. Historically, the Fed raises short-term rates to slow an overheated economy following a period of economic expansion. As the economy expands, inflationary pressures start to build over time, forcing the Fed to raise short-term borrowing costs to slow the economy.

Monitoring the spread between the 2 year treasury rate and the 10 year rate provides a fairly reliable recession predictor. The Fed never wants to raise the rates so much as to force the economy into a recession. Satisfying the stable price mandate is the goal.

Unfortunately, how much to raise short-term rates in order to lower inflation to an acceptable rate (generally less than 2%) is not an exact science. Historically, to crush inflationary expectations, short-term rates must be raised to the point that the economy declines into a recession. Prior to a recession, it is common for the 2 year rate to exceed the 10 year rate. This is called an inverted yield curve.

The graph presents the spread since 1975 with the shaded areas representing recessions. Notice how the spreads tend to narrow—and in most cases the 2 year exceeds the 10 year yield—prior to the beginning of a recession. Monitoring the spread trend provides economists with insight into the probabilities of a Fed-induced recession. Of course, recessions can be caused by other factors, but the predictive power of this monitor is impressive.

Spreads of late have been widening as the 10 year rate is trending higher. In fact, the spread is closer to the all-time high, indicating a lack of inflationary pressure. The current inflation rate is well below the Fed’s target rate of 2% and moving lower.

In summary, the spread predictor is pointing to a sustained period of economic growth.

First Affirmative understands that the ways we save, spend, and invest can dramatically influence both the fabric and consciousness of society. We believe that in addition to the benefits of ownership, investors bear responsibility for the impact our money has in the world. Are you making conscious decisions about the impact of your consumer purchase and investment decisions?

Posted: December 5, 2013