Esther George, Speech: The Path to Price Stability

“Finally, the interaction of higher policy rates with a large balance sheet will need to be considered. Raising short-term rates while the balance sheet continues to depress longer-term yields will contribute to a flattening and inversion of the yield curve. Already, as markets have anticipated a rapid increase in short-term rates, the spread between the yield on the 2-year and 10-year Treasury bond turned negative yesterday. While many factors influence longer-term yields, including the growth outlook, foreign demand for Treasuries, and the quantity and maturity of Treasury debt issuance, the Fed’s asset holdings also play a role. These purchases aimed to depress long-term rates, and the roll-off of these assets is likely to put some upward pressure on those rates, possibly steepening the yield curve.”

“My concern about an inverted yield curve does not reflect its intensely debated value as a predictor of recession. Rather, my view is that an inverted curve has implications for financial stability with incentives for reach-for-yield behavior. An inverted yield curve also pressures traditional bank lending models that rely on net interest margins, or the spread between borrowing short and lending long. Community banks in particular rely on net interest margins to maintain their profitability, with rural areas especially dependent on community banks.”