Texas Border Business
By Teo Sepulveda, Economist from South Texas College
As of late, there have been fears of a recession in the financial markets and around academic economic circles. But it seems those fears can reside for now. The yield curve, an important economic indicator, had inverted bringing fears of a recession. The central bank of our nation (the FED) took steps to correct the indicator. So, for now, the yield curve is back to normal. Our financial future looks brighter, but that does not mean we can ignore and forget what just happened.
The yield curve is an indicator of the difference between short-term interest rates and long-term rates. The typical form of that relation is that long-term rates tend to be higher than the short-term ones. This because it makes sense that a borrower that is going to make her creditors wait longer, should compensate them more.
It is common for some businesses to borrow short-term to finance long-term projects. For once, because shot-term rates are less expensive and because longer-term projects have a higher level of uncertainty when it comes to their final maturity date. So, it makes sense to borrow short-term and just refinance long-term projects more often than otherwise.
However, we face a dilemma. For once, since we are enjoying very low levels of unemployment and the inflation rate is averaging just above 2% per year, the FED is supposed to reduce the monetary base to prevent inflation from getting out of hand. This action causes short-term rates to rise. Second, the federal deficit unintentionally pushes short-term rates up also, since most government borrowing is short-term. Therefore, two forces are pushing short-term rates up.
This scenario above, causes many private investment projects to find it more difficult to refinance, and so the final output of those projects might not reach the aisles of retail companies. This can cause an economic slowdown like the one we have seen in output and employment since the 3rd quarter of 2018.
To solve this issue the FED increased the monetary base to reduce short-term rates, and so the yield curve has reverted to its original form: short-term rates are now lower than long-term rates. This way, many investment projects currently in process can come to fruition and recession can be avoided. But it could also be just postponed.
We can conclude that the FED has done its job by stabilizing economic activity through a new method that we can label in the interim as “yield curve management or targeting.” However, the FED will not always be able to do it if inflation gets out of hand. Because of that, we ought to continue to pay attention to monetary developments.
Teo Sepulveda is an economist currently working for South Texas College. Born in Houston, Texas and raised in Monterrey, Mexico, he has made the Rio Grande Valley his home since the early 2000s. He graduated with a Masters’ degree in Economics from Georgia Southern University and a bachelor’s in mathematics from UTRGV.