Economic Letter

Some governments sell bonds that protect against variation in inflation. Payments of these bonds are adjusted in response to official inflation measurements with a lag. Considering the effects of such lags could matter both for understanding market-based measures of inflation compensation and for governments deciding what type of inflation-indexed securities to issue. Analyzing pairs of U.K. bonds with almost identical maturities but different lags in inflation adjustment suggests that the lag length matters mainly close to maturity, when seasonality in the underlying price index plays a role.

The term spread—the difference between long-term and short-term interest rates—is a strikingly accurate predictor of future economic activity. Every U.S. recession in the past 60 years was preceded by a negative term spread, that is, an inverted yield curve. Furthermore, a negative term spread was always followed by an economic slowdown and, except for one time, by a recession. While the current environment is somewhat special—with low interest rates and risk premiums—the power of the term spread to predict economic slowdowns appears intact.

Recent research suggests that sustained accommodative monetary policy has the potential to increase financial instability. However, under some circumstances tighter monetary policy may increase financial fragility through two channels. First, a surprise tightening tends to reduce the market value of banks’ equity and raise their market leverage, exacerbating balance sheet fragility in the short run. Second, increases in the federal funds rate have historically been followed by an expansion of assets held by money market funds, which proved to be a source of instability in the 2007-09 financial crisis.

Labor market networks are informal connections among neighbors, coworkers, family, and friends that help people find jobs through sharing information about job openings or applicants. These networks appear to play a valuable role in helping workers recover after mass layoffs. Among relatively low-skilled workers who lost their jobs in mass layoffs, those living in neighborhoods with stronger labor market connections among neighbors found new jobs more quickly. Moreover, workers who found jobs through network connections also found better positions that paid more and lasted longer.

U.S. output has expanded only slowly since the recession trough in 2009, counter to normal expectations of a rapid cyclical recovery. Removing cyclical effects reveals that the deep recession was superimposed on a sharply slowing trend in underlying growth. The slowing trend reflects two factors: slow growth of innovation and declining labor force participation. Both of these powerful adverse forces were in place before the recession and, thus, were not the result of the financial crisis or policy changes since 2009.

The expansion is proceeding at a good pace, unemployment is low, and inflation is finally headed in the right direction. The data show no signs of an economy going into overdrive. This suggests that further gradual increases in interest rates are likely in 2018, assuming the data continue to come in largely as expected. The following is adapted from remarks by the president and CEO of the Federal Reserve Bank of San Francisco to the Financial Women of San Francisco on February 2.

When lenders experience unexpected losses, the supply of credit to borrowers can be disrupted. Researchers and policymakers have long sought estimates of how the availability of loans changes following a shock. The sudden oil price decline in 2014 offers an opportunity to observe precisely how affected lenders altered their portfolios. Banks that were involved with oil and gas producers cut back on some types of lending—consistent with traditional views of bank behavior. However, they expanded other types of lending and asset holdings with a bias towards less risky securities.

Current valuation ratios for U.S. equities and household net worth are high relative to historical benchmarks. The cyclically adjusted price-to-earnings ratio reached its third highest level on record recently, and the ratio of household net worth to disposable income, which includes a broad set of household assets, stands at a record high. Such extreme values of these ratios have historically been followed by reversions toward their long-run averages. However, other current factors, such as low interest rates, caution against bearish forecasts.

The economy is in a good place. Unemployment is low and confidence is high. The challenges to address are good ones: keeping the expansion going, bringing inflation up to its 2% target, and using this period to normalize monetary policy in general and interest rates in particular. The years ahead will require a balanced approach, guided by the data. The following is adapted from remarks by the president and CEO of the Federal Reserve Bank of San Francisco at the 54th Annual Economic Forecast, Phoenix, AZ, on November 29.