Kaplan Backs Three 2018 Fed Hikes, Warns on Inverted Yield Curve

(Bloomberg) -- Federal Reserve Bank of Dallas President Robert Kaplan cautioned against speeding up the pace of interest-rate increases by the U.S. central bank, in part due to concerns over a narrowing spread between short-term borrowing costs and longer-term yields.

Fed officials lifted rates three times in 2017. Projections released in March showed a fairly even split between policy makers who favored three hikes this year and those who wanted four, and investors are increasingly leaning toward the latter.

Kaplan Backs Three 2018 Fed Hikes, Warns on Inverted Yield Curve

The “yield curve is one of the considerations on my mind, which is why I’m not jumping away from three as a base case,” Kaplan said Tuesday in a Bloomberg News interview. “I don’t want to knowingly invert the yield curve, but I think it’s too soon to say how much operating flexibility we are going to have."

The former Goldman Sachs executive, who does not vote on policy this year, has previously warned about an inverted yield curve -- when short-term rates rise above long-term ones -- because it has typically presaged economic downturns.

That possibility appears to be getting more likely. The spread between the yield on 10-year U.S. Treasury notes and that on 2-year notes narrowed last week to less than half a percentage point, marking the smallest gap since 2007. Though the 10-year yield has been rising, the 2-year yield -- which is more sensitive to expectations for Fed interest-rate moves in the short term -- has been going up faster.

While yield-curve inversion has long been used on Wall Street as a recession indicator, interest-rate projections the Fed began making public in 2012 have put a new spin on it. The latest projections, from March, shown in the so-called dot plot, suggest most participants on the U.S. central bank’s rate-setting Federal Open Market Committee expect it will be appropriate in 2020 to raise rates above their estimates of the long-run neutral rate, in order to cool an overheating economy and avoid a recession.

Kaplan Backs Three 2018 Fed Hikes, Warns on Inverted Yield Curve

Of the 14 FOMC participants who submitted projections in March, 11 of them saw the neutral rate probably somewhere between 2.5 percent and 3 percent. Kaplan said his own estimate is within that range.

The central bank lifted the target range for its benchmark overnight policy rate to 1.5 percent to 1.75 percent in March.

“I’d like to first get to neutral, see if we can do that, and then we’ll have to make a judgment when that time comes” about whether to continue raising rates, Kaplan said. “But even in my dot plot submissions, I would not be submitting estimates that would, in my view, knowingly invert the yield curve.”

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