Some economists are beginning to speculate the Federal Reserve will go too far in raising rates and could overshoot its neutral target, which may cause the yield curve to invert for the first time since 2000. Yield curve inversion typically foreshadows a recession, as it did five years ago.
Mixed economic data has convinced many economists the U.S. is in the midst of a soft patch. In addition, comments such as the recent speech by Fed governor Donald Kohn indicated the Fed will continue to raise rates despite the possibility higher rates could increase debt burdens or pop the housing price bubble. As a result, the 2s/10s curve has resumed flattening, going to 61 basis points on April 26 from 72bps on April 1. "The big question is, 'When does the flattener signal 2006 will have slow growth because the Fed has overshot neutrality,'" said John Herrmann, director of economic commentary at Cantor Viewpoint. He cautioned the inversion scenario would depend on the Fed Funds rate reaching 3.75% while the current economic soft patch becomes entrenched.
Other economists dismissed the possibility of a curve inversion. "Rates are heading for 5% based on solid growth and core inflation edging up," said Jim O'Sullivan, senior economist at UBS. He said a Fed Funds rate higher than 4.5% could be considered restrictive but forecasts the Fed will stop raising rates at 4%.
