Bostic Throws Down the Gauntlet

Atlanta Federal Reserve President Raphael Bostic threw down the gauntlet today with a declaration to dissent any policy move that will invert the yield curve. He may get the chance to make good on that threat in December – his last meeting in his current rotation a voting member.

Bostic, via Bloomberg:

“I pledge to you I will not vote for anything that will knowingly invert the curve and I am hopeful that as we move forward I won’t be faced with that,’’ Bostic said Monday in Kingsport, Tennessee, in response to an audience question. “The market is going to do what the market does, and we have to pay attention and react.’’

Arguably, there is some wiggle room here – the criteria for dissension is that the policy must “knowingly” invert the yield curve. And I suppose he could abstain from voting rather than dissent.  Moreover, it is important to know what he views to be the relevant portion of the curve. Is it the 10-2 spread? Or the 10-Fed Funds spread? Inquiring minds want to know!

Still, Bostic reveals here a fairly strong conviction that the yield curve must be taken seriously as a warning sign that policy is in danger of turning too tight. His hopefulness that the Fed will not be faced with this decision, however, might be misplaced.

The 10-2 spread has narrowed to 24 basis points. Still not a recession indicator, or even an indicator of weakness in my opinion. What I am looking for is 10-2 inversion plus continued Fed tightening as a recession warning signal. But it is fairly easy to see how a Fed hike in September combined with expectations of continued gradual rate hikes into 2019 pushes the 10-2 spread close to inversion by the time the December meeting rolls around. It is also fairly easy to see that the US economy retains enough strength to justify a rate hike at that meeting. A rate hike at that point could reinforce future rate hike expectations and then push the curve into inversion. This would give Bostic the opportunity to follow through with his threat and dissent – if of course the 10-2 spread is the relevant spread.

Alternatively, if the 10-Fed Funds spread is his focus, his threat might be fairly meaningless as that inversion would not happen until much later. And probably by the time that happens a recession would be baked in the cake. In other words, his threat is only meaningful if he focuses on the long-leading indicator of the 10-2 spread.

And more importantly his threat means little to policy unless he can pull a significant portion of the voting FOMC members in his direction. While some Fed regional presidents are sympathetic to Bostic’s position, they still make up a minority of policy makers. Nor are they voting now. My guess is that given the 10-2 spread is such a long leading indicator, it will invert at a time when that data, from the Fed’s perspective, supports further rate hikes. Hence they are likely to hike through an inversion.

Bottom Line: My sense is that the majority of the Fed would find more reasons to ignore than embrace the signal from a 10-2 yield curve inversion. They will fall back on the basic theory that this time is different because the curve inverts at a lower level of rates than in previous inversions. If the yield curve doesn’t stop them from continuing rate hikes, what will? Certainly a clear slowdown in activity would do the trick. But that is obvious. Less obvious is the possibility that they pause after reaching their estimates of neutral even if the data remains consistent with above-trend growth. That would require something of a leap of faith by Powell & Co. that the lagged impacts of tightening had yet to materialize in a slower pace of activity.