A significant reason an inverted yield curve can potentially predict a recession is why an inverted yield curve occurs. Generally, the yield curve slopes up (long-term interest rates are generally higher than short-term interest rates). There tends to be more inflation in the long-term, and investors and lenders need to be compensated for the higher inflation. In addition, there is generally greater economic risk that attaches to the long-term. As a result, in the U.S., long-term interest rates are usually higher than short-term interest rates. An inverted yield curve, when short-term interest rates are higher than long-term interest rates, reflects increases in short-term interest rates and an expectation that inflation (and interest rates) will decrease in the long-term. The usual cause of increasing short-term interest rates is a change in Federal Reserve policy. The Federal Reserve increases short-term interest rates to bring about an economic slowdown to fight inflation. The Federal Reserve targets the federal funds rate, a very short-term interest rate, which is the overnight borrowing rate between banks. Increasing the federal funds rate can lead to an economic slowdown (and inverted yield curve), but too much of an economic slowdown can precipitate a recession. While an inverted yield curve has historically been a very good indicator of pending recessions, it is not foolproof, and cannot predict the duration and severity of recessions. Inflation The table below shows the annualized inflation rate for Europe, Mexico, the United Kingdom, Canada, and the United States for selected months in 2022 and spring 2023 compared to April 2021. Note that the trends in price increases are similar across most countries, with relatively low inflation in April 2021 transitioning to relatively high inflation in 2022. Global factors have impacted global prices, including spikes in oil and wheat prices that resulted from Putin’s invasion of Ukraine, and supply chain issues. Record levels of inflation occurred around the world.
Contributions to Percent Change in Real Gross Domestic Product– Annualized Rate (Source: Bureau of Economic Analysis)
April 21 April 22 June 22 Dec. 22 Jan. 22 Feb. 23 Mar. 23
Euro Area
1.6 3.4 1.5 6.1 4.2
7.4 6.8 9.0 7.7 8.3
8.6 8.1 9.4 7.9 9.1
9.2 6.3
8.6 5.9
8.5 5.2
6.9 4.3
Canada
United Kingdom
10.5
10.0
10.4
10.1
Mexico
7.8 6.5
7.9 6.4
7.6 6.0
6.8 5.0
U.S.
Generally, in 2023, global inflation slightly decreased as supply chain issues faded and energy and food markets stabilized. (The U.K. faces the unique economic challenges that have arisen since Brexit.) Although inflation remains relatively high in the U.S. compared to historical levels, the 5.0 percent inflation rate for the 12 months ending March 2023 was the smallest 12-month increase since the period ending May 2021. The March 2023 annualized inflation rate reflects increased product input prices, a strong labor market, fluctuating commodity prices, and strong corporate profitability over the previous 12 months. The following table shows price changes for selected products over the 12-month period ending in March 2023 and the seasonally adjusted monthly price change in March compared to February. Major product categories include Food, Energy, and all items less Food and Energy (which is also called “core inflation”). For the 12-months ended March 2023 overall inflation declined to 5.0%, with core inflation (all items less food and energy) at 5.6%.
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Center for Business and Economic Insight
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