Hawkish Federal Reserve and Inverted Yield Curve Point to a Recession

The U.S. Federal Reserve was late to the inflation taming party and has had to raise its key lending rate at a torrid pace since the start of 2022 to curb decades-high inflation. Most people forget, but in the first quarter of 2022, the Federal Reserve held the federal funds rate at around zero.

Throughout the remainder of 2022 though, the central bank raised the federal funds rate seven times, by nearly five percentage points, from a range of 0% to 0.25% to a range of 4.25% to 4.50%. In February of 2023, the U.S. Federal Reserve raised its key lending rate by an additional 25 basis points to a range of 4.50% to 4.75%.

Is the Federal Reserve Going to Continue Raising Interest Rates?

Inflation still remains stubbornly high, which means the Federal Reserve will continue to raise interest rates in 2023, faster and higher than anyone expected. Federal Reserve Chair Jerome Powell said recently that inflation may be moderating, but the process of getting inflation under control “has a long way to go and is likely to be bumpy.”

The latest Consumer Price Index shows that prices climbed 6.4% year-over-year in January. That’s down from last summer’s peak inflation of 9.1%, but way above the Fed’s 2% target.

Back in December, the Fed said it would probably need to rise interest rates to a range of 5.0% to 5.25%. It’s now looking as if it will surpass that target. Powell’s remarks now suggest a hike of 50 basis points is more likely when it meets next on March 21-22.

What Is an Inverted Yield Curve?

Hawkish comments by Jerome Powell have helped push the U.S. Treasury yield curve to its deepest inversion since 1981—a bullish recessionary signal. The yield curve typically slopes upward as the payout increases over time. Like a dividend, the yield moves inversely to prices. The higher the price, the lower the dividend.

A steepening yield curve typically points to stronger sentiment for the economy, higher inflation, and interest rates. A flattening curve, meanwhile, means investors expect near-term rate hikes and are pessimistic about economic growth.

An inverted curve happens when yields on short-dated Treasures climb above the yield for long-term ones and suggests that investors expect interest rates to rise in the near term, with higher borrowing costs hurting the economy, and tipping it into a recession. In fact, an inverted yield has predicted the past seven recessions.

On the plus side, it also means the Federal Reserve will have to eventually east its monetary policy.

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The U.S. Federal Reserve will need to raise interest rates faster and higher than expected to bring down stubbornly high inflation to its target range of two percent, a move that is expected to tip the economy into a recession.

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