Philadelphia Reflections

Will Tax Cuts Invert the Yield Curve?

For those who just came in, let's explain a normal yield curve, and then an inverted one. In plain English, average interest on short-term bonds is normally smaller than average interest on long-term bonds, so a line drawn between them slopes upwardly. This reflects the reality that the risk of something going wrong is less in a short time than during a long one, so an up-trending yield curve is what emerges when everyone leaves interest rates alone. However the Federal Reserve has for a century adjusted short-term rates according to its view of whether banks should do more or less lending, whether inflation should be encouraged or discouraged, or whether the banking industry needs more or less profitability; sometimes these goals conflict, and sometimes the Fed is merely trying to maintain a stable spread when long term interest rates shift in response to market forces. In average circumstances the marketplace alone controls long term borrowing costs by supply and demand; long term rates are whatever they happen to be. However, Chairman Bernanke has introduced what he calls "Quantitative easing", which is to intervene directly in long term pricing by purchasing and selling long-term bonds. Therefore, the slope of the yield curve can reflect many motives; it's hard to deduce motive from changes in the slope of the yield curve alone. Indeed, 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, rates can eventually approach the point where bond interest is essentially tax-exempt. Paying more interest, long-term rates are thus normally affected more than short ones by the change. However, a preponderance of U.S. Treasury bonds is now purchased by foreigners who are indifferent to our tax rates. It's clear, however, that cutting taxes will lower bond market interest rates in the general direction of tax-exempts. Although tax reduction is capable of inverting the yield curve, it may no longer do so, and the Federal Reserve may be relieved of lowering short term rates to maintain balance.

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 depress the yield curve still further.

By this line of reasoning, an inverted yield curve is no longer a reliable portent of trouble, because it no longer primarily reflects American owners of the bonds dumping them. It has some important consequences, however. If interest rates are lower, retired people, insurance companies and pension annuities will be financially worse off. Borrowers, however, will 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. As different segments of the population are affected differently, the main outcome might well be a political one.

There are, from this example, lots of mixed consequences to be expected from a general readjustment (?reform?) of tax rates. But it shouldn't be a mystery that tax consequences affect yields, yield curves, and politics. That effect may not even be a conundrum.

Originally published: Thursday, June 22, 2006; most-recently modified: Wednesday, June 05, 2019