Did Tax Cuts Invert the Yield Curve?
For those who just came in, let's explain an inverted yield curve. In plain English, it means that interest on short-term bonds (set by the Federal Reserve) is larger than interest on long-term bonds (set by the public in the bond market.) That's the opposite of the normal situation, and regarded as an ominous signal of impending economic troubles. But suppose it doesn't have much to do with economic forecasting at all. Suppose it just reflects tax cuts.
After all, when federal taxes are reduced, you eventually approach the point where bond interest is essentially tax-exempt. Everyone knows tax-exempt bonds pay less interest than taxable ones. For this purpose, it doesn't much matter whether income tax, capital gains tax, or dividend taxes are reduced. This creates a small problem for the argument, because several taxes have been cut by differing amounts and thus it isn't possible to calculate the precise level by which interest rates on government bonds should have been effectively reduced. It's clear, however, that cutting taxes will lower bond market interest rates in the general direction of tax-exempts. Since the yield curve is just a ratio of these rates, compared to the short-term rates set by the Federal Reserve, the yield curve is distorted and eventually "inverted".
If there is anything to this idea, the yield curve might have inverted without a tax cut. That's because a majority of U. S. Government bonds are lately being purchased by Asian governments. The Chinese government doesn't pay U.S. taxes, so to them all American bonds are tax-exempt. Federal bonds are a little safer than municipal government bonds, so they should command a little lower interest rate, and may eventually invert the yield curve still further.
By this line of reasoning, the inverted yield curve is not a portent of trouble, because it no longer primarily reflects American owners of the bonds dumping them. It does, however, have some important consequences. If interest rates are lower, retired people, insurance companies and pension annuities are going to be financially worse off. Borrowers, however, are going to be better off, and within limits the economy will be favorably stimulated. One can be uneasy about the overall effect on the real estate and insurance markets, and on the temptation to governments to borrow more than they can repay.
There are lots of mixed consequences to be expected from a general readjustment of the tax rate. But it shouldn't be a mystery that tax consequences affect yields and yield curves. It may not even be a conundrum.
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