Opposing view: Rate reduction provides economic insurance

The Federal Reserve is expected to take out an economic insurance policy this week and lower interest rates by 25 basis points. Some have even argued to stand pat, to save the “interest rate ammunition” for when it is most needed, not when the unemployment rate is close to a five-decade low.

Interestingly, the case for a 50 basis point cut might be even the best course of action. Here is why: The yield curve — the difference between the rate on Fed funds and the 10-year Treasury note — is positive. This is a very unusual financial situation, and it should worry market participants and monetary policymakers alike.

This inversion is a problem for two reasons. One issue is the markets’ tendency for accurately predicting economic inflection points. The other is the likely slowdown in money and credit creation that will result over time from an inverted curve.

When the yield curve inverts, meaning short-term rates are above longterm rates, it almost has always predicted a looming recession. Since 1960, we count only one false positive (1966) when inversion did not precede recession in a reasonably short period.

This “wisdom of crowds” perspective has been more accurate than the Fed, which has never predicted a recession. If so, the Fed should not wait for more evidence of a slowdown, because the market is already telling us one is coming.

The other concern is a lack of money and credit creation. Because banks “borrow short and lend long,” the inverted curve causes firms to ration credit. This is because their cost of funds is higher than the return on those funds. Over time, credit — an important lubricant for growth — contracts. Economic headwinds mount.

Last month, the Fed funds rate averaged about 30 basis points above the 10-year Treasury note. Hence, a 25 basis point rate cut, let alone no change in interest rates, would not be enough to reverse today’s ominous situation.