Back in mid-December 2016, the Fed started raising the federal funds rate by 0.25 of a percentage point per quarter. So, the federal funds rate has risen a cumulative 1.50 percentage points since then. When the Fed began these quarterly federal funds hikes back in mid-December 2016, the difference, or spread, between the yield on the Treasury 10-year security and the federal funds rate was 2.13 percentage points. In the week ended August 31, 2018, this spread had narrowed to 0.96 of a percentage point. Thus, since mid-December 2016 through the week ended August 31, 2018, the federal funds rate has risen by 1.50 percentage points as the yield on the Treasury 10-year security has fallenby 0.33 of a percentage point. The yield curve has flattened as a result of the combination of a risein short-maturity interest rates and a declinein long-maturity interest rates. Unless the economic landscape changes radically in the interim, the Fed is likely to raise the federal funds rate another 0.25 of a percentage point on this coming September 26. If the recent past is prologue, the spread between the Treasury 10-year security and the federal funds rate will narrow further.
I mention this narrowing in the spread between the yield on the Treasury 10-year security and the federal funds rate, or the flattening in the yield curve, because the behavior of the yield curve has the uncanny characteristic of presagingthe pace of real domestic demand for goods and services. That is, as the yield curve flattens, growth in real domestic demand slows with a lag. Conversely, as the yield curve steepens (the yield on the Treasury 10-year security rises relative to the federal funds rate), growth in real domestic demand increases with a lag. This leading relationship between the flattening/steepening behavior of the yield curve and the decreasing/increasing growth rate of real domestic purchases is shown in Chart 1 where the red bars represent the observations of the four-quarter moving average of the yield spread in percentage points and the blue line represents the year-over-year percentage changes in quarterly observations of the real gross domestic purchases (real gross domestic product plus imports and minus exports). The vertical shaded areas in the chart represent periods of business-cycle recessions. Notice that the spread between the yield on the Treasury 10-year security and the federal funds rate typically becomes negative priorto the onset of a recession. The exception to this was the recession that commenced in Q2:1960. Although the yield spread narrowed prior to the onset of this recession, it did not turn negative. In late 1966, the yield spread turned negative, but a recession did not occur. Although real gross domestic purchases did not contract, growth did slow precipitously. As I mentioned in a previous commentary, my former colleague at the Chicago Fed, Robert D. Laurent, did seminal research on the leading-indicator characteristic of the behavior of the yield curve. Rest in peace, Bob.