Edward Conard

Top Ten New York Times Bestselling Author

  • “…a comprehensive explanation of the modern economy.” - Julian Robertson, Founder, Tiger Management
  • “…a very valuable contribution.” - Larry Summers, former Secretary of the Treasury and director of the National Economic Council, president emeritus, Harvard University
  • “…serious thinking for serious thinkers. …a thought-provoking blueprint for growing middle- and working-class incomes.” - Mitt Romney, former Governor of Massachusetts
  • “…a very valuable contribution.” - Larry Summers, former Secretary of the Treasury and director of the National Economic Council, president emeritus, Harvard University
  • “…serious thinking for serious thinkers. …a thought-provoking blueprint for growing middle- and working-class incomes.” - Mitt Romney, former Governor of Massachusetts
  • “Unintended Consequences should be read by anyone who takes for granted the superiority of progressive taxation and has not thought carefully about the trade-offs involved.” - The New Republic
  • “Unintended Consequences offers deep and well-argued analyses on almost every issue.” - The New York Times
  • “…a must-read for serious students of economic policy.” - Glenn Hubbard, Dean, Columbia Business School, and former Chairman of the Council of Economic Advisers
  • “…reminds us that inequality sends a signal of what society lacks most, in America’s case, entrepreneurship and risk taking.” - Lawrence Lindsey, CEO, The Lindsey Group, former Director of the National Economic Council
  • “…a fresh argument for the productive value of inequality.” - David Autor, Professor of Economics, Massachusetts Institute of Technology
  • “…a comprehensive explanation of the modern economy.” - Julian Robertson, Founder, Tiger Management
  • “…reminds us that inequality sends a signal of what society lacks most, in America’s case, entrepreneurship and risk taking.” - Lawrence Lindsey, CEO, The Lindsey Group, former Director of the National Economic Council
Upside of Inequality Oxford Unintended Consequences

AI Summary. An inverted yield curve — when short-term U.S. Treasury yields exceed long-term yields — has consistently preceded recessions and may also help cause them by squeezing bank profit margins. The author argues that during past inversions banks tightened lending standards, reducing loan supply and dampening economic activity.

David Wheelock Federal Reserve Bank of St. Louis
Date Posted:
Is Database:
Database

Yield curve inversions aren’t just a leading indicator of recessions but a cause of them as they pinch bank margins and contract loan activity.

Does an inverted yield curve cause recessions by tightening bank lending?

Core argument: An inverted yield curve, where short-term U.S. Treasury yields exceed long-term yields, has consistently predicted recessions and may also cause them by squeezing bank profit margins and prompting tighter lending standards.

An inverted yield curve, where short-term U.S. Treasury yields exceed long-term yields, has consistently predicted recessions and may also cause them by impacting bank operations. When the yield curve inverts, banks' profit margins are squeezed as short-term rates rise relative to long-term asset yields, prompting banks to tighten lending standards. Historical data shows that during past inversions, such as in 2000 and 2006, the net percentage of banks tightening lending standards increased, leading to reduced loan supply and slower economic activity. This contraction in loan activity can directly contribute to economic slowdowns, suggesting that yield curve inversions do more than forecast recessions; they can actively trigger them by constraining credit availability and dampening economic growth.

Takeaways by Macro Roundup® AI

  1. An inverted yield curve, where short-term U.S. Treasury yields exceed long-term yields, has consistently predicted recessions and may also cause them by squeezing bank profit margins and prompting tighter lending standards.
  2. During the 2000 and 2006 inversions, the net percentage of banks tightening lending standards increased, reducing loan supply and slowing economic activity.
  3. The argument holds that yield curve inversions do more than forecast recessions and can trigger them by constraining credit availability and dampening economic growth.

blog post/chart from St. Louis Fed, yield curve inversions aren’t just a leading indicator of recessions but a cause of them. can pinch bank lending margins and contract loan activity. the curve isn’t inverted now, but the spread has flattened.

“…An inverted yield curve—or a situation in which market yields on shorter-term U.S. Treasury securities exceed those on longer-term securities—has been a remarkably consistent predictor of economic recessions. However, simply because inversions forecast recessions does not necessarily mean that inversions cause recessions. Why might a yield curve inversion cause economic activity to slow?….The figure below illustrates the tendency of banks to tighten lending terms when the yield curve inverts. It plots the yield on 10-year Treasury securities minus the yield on two-year securities….Why is this important? Researchers have found that the economy tends to slow after banks tighten their lending standards, suggesting that an inversion of the yield curve could cause economic activity to slow by leading banks to reduce the supply of loans.3Thus, an inverted yield curve might do more than predict a recession: It might actually cause one….”

Normally, the yield on 10-year securities exceeds the yield on two-year securities, reflecting the fact that the yield curve is usually upward sloping. The yield curve is downward sloping (or inverted) when the yields on shorter-term securities are higher than those on longer-term securities, as in 2000 and 2006. Both of those inversions were followed by the start of a recession within a few months.

The Fed has surveyed banks on their lending terms continuously since 1990.2 The chart shows that the net percentage of banks tightening their lending standards on commercial and industrial loans began to rise around the time that the yield curve inverted in 2000 and 2006.

Why is this important? Researchers have found that the economy tends to slow after banks tighten their lending standards, suggesting that an inversion of the yield curve could cause economic activity to slow by leading banks to reduce the supply of loans.3 Thus, an inverted yield curve might do more than predict a recession: It might actually cause one.

Notes and References

1 October 2018 Senior Loan Officer Opinion Survey on Bank Lending Practices.

2 The Fed also surveyed banks on their lending terms from 1967 to 1983.

3 Lown, Cara S.; Morgan, Donald P.; and Rohatgi, Sonali. “Listening to Loan Officers: The Impact of Commercial Credit Standards on Lending and Output.” Federal Reserve Bank of New York Economic Policy Review, July 2000. Also, Bassett, William F.; Chosak, Mary Beth; Driscoll, John C.; and Zakrajsek, Egon. “Changes in Bank Lending Standards and the Macroeconomy.” Journal of Monetary Economics 2014, Vol. 62,pp. 23-40.

The figure below illustrates the tendency of banks to tighten lending terms when the yield curve inverts. It plots the yield on 10-year Treasury securities minus the yield on two-year securities.

Can an Inverted Yield Curve Cause a Recession?

An inverted yield curve—or a situation in which market yields on shorter-term U.S. Treasury securities exceed those on longer-term securities—has been a remarkably consistent predictor of economic recessions. However, simply because inversions forecast recessions does not necessarily mean that inversions cause recessions. Why might a yield curve inversion cause economic activity to slow?

Banking and Yield Curve Inversions

One possible channel is through the banking system. Banks engage in maturity transformation. That is, on average, the loans in a typical bank’s portfolio have a longer term to maturity than the deposits and other funds they use to finance those loans. In essence, banks transform their short-term liabilities (such as deposits) into longer-term assets (such as business and consumer loans).

Normally, banks can profit on the spread between the yields on longer-term assets and the interest they pay on deposits and other short-term liabilities. However, bank profits get squeezed when short-term interest rates rise relative to the yields on long-term assets. This can lead banks to cut back on their lending, which, in turn, can put the brakes on economic activity.

Tightening Lending Standards

Recently, the Federal Reserve asked banks how their lending policies might change in response to a hypothetical moderate inversion of the yield curve.1 Many of those surveyed indicated that they would tighten lending standards or price terms on every major loan category.

When asked why they would do so, several potential reasons were given:

David Wheelock, “Can an Inverted Yield Curve Cause a Recession?,” Federal Reserve Bank of St. Louis, December 27, 2018, https://www.stlouisfed.org/on-the-economy/2018/december/inverted-yield-curve-cause-recession

  • An inversion could cause loans to be less profitable relative to the bank’s cost of funds.
  • An inversion would cause their banks to be less risk tolerant.
  • An inversion may signal a less favorable or more uncertain economic outlook.
Showing 246 database articles primarily about Financial Markets