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Monday, July 10, 2006

Ben and the yield curve...

This graph was in the latest edition of Mr. Model, an economics newsletter by Robert F. Dieli. It shows the effect of Federal Funds Rate policy on the US economy. It also highlights the periods where the yield curve was abnormal (inverted).

Dr. Dieli arrived at the conclusion that when the fed funds are north of 5.50% the US economy does not fair too well. We can see that the last six recessions happened shortly after the yield curve inverted and the Fed Funds rate was above the 5.50% level. The only exception was the 1982-1990 expansion period. However, the main difference between now and the mid-80's was that core inflation was on a downtrend. Today we face continued inflation pressure as energy prices advance to record territory. The odds of core inflation peaking or reversing in the short-term are diminishing rapidly as crude futures move past $75.

So is it all gloom and doom? Its starting to look like it. But there is still a chance that Mr. Bernanke can hold the line and navigate the US economy to a soft landing. If June-July PCE inflation numbers stay within the FOMC's comfort zone of 2% maybe he would stop raising rates. This will give us an environment similar to the mid-90s where Greenspan was successful at taming inflation and avoiding a recession despite having an inverted yield curve. If Ben can mimic Alan's success, then the Fed's reputation as an inflation fighter will be enhanced.

I will leave you with the same questions Dr. Dieli ended his newsletter with: Can the FOMC engineer a solution that keeps us within hailing distance of the 5.50% line? How will Ben Bernanke restrain inflation and avoid an inverted yield curve with just one tool?



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