This article first appeared in Forum, The Edge Malaysia Weekly on April 4, 2022 - April 10, 2022

The yields on US Treasury debt papers — the largest and most significant debt-capital market in the world — is a closely watched economic indicator for an important reason.

This is because in the last 50 years, when the yields on the shorter-term two-year US Treasury debt papers were higher than those of the 10-year papers, a recession happened.

The recession does not take place immediately but one or two years after the yields on the short-term debt papers exceed that of the 10-year papers — a development that is described as an inverted US Treasury yield curve.

By convention, the shorter-term debt papers should carry a lower yield compared with the longer-term debt papers. This is because longer-term borrowings carry a higher risk, thus investors demand higher returns.

When the reverse happens, the economic interpretation is that the short-term economic environment is not healthy compared with the longer-term prospects. The last time it happened was in 2019. A year later, the Covid-19 pandemic broke out and sparked a recession.

Last Thursday, the yields on the two-year US government debt papers were higher compared with the 10-year debt papers for some parts of the day.

Does this herald a recession a year or two down the road? Not necessarily.

First, the yields on the two-year Treasury papers were only marginally higher than the longer-term 10-year papers. At the time of writing, the two-year papers were yielding 2.33% and the 10-year papers, 2.35% — a gap of only 0.02%. A year ago, the gap was more than 0.5%.

For a recession to happen, the yields on the two-year papers should consistently be above or almost on a par with the 10-year papers for some time.

Second, the short-term yields shot up because of expectations that the Federal Reserve would take a more aggressive approach in raising interest rates to tame inflation.

On March 17, the Fed set the federal funds rate at between 0.25% and 0.5%, the first time it had increased the rate since 2018. The US central bank has indicated that there could be six more rate hikes throughout this year and next year.

Inflation is rearing its ugly head again all over the world because of the pandemic. In the US, inflation is at a 40-year high while in Malaysia, inflation is hitting more than 3% when, historically, it has been subdued around 2%. Prices of goods and crucial commodities such as crude oil and food have risen multiple times, increasing the cost of living.

Fighting inflation with higher interest rates is the textbook solution to bringing the economy to an equilibrium. However, the current form of inflation is different than in other times. This time, it is caused by a major disruption in the global supply chain, owing to the pandemic. It is not only the ports that were congested. People’s mobility also came to a standstill, causing a huge shortage of labour and a reduction in production.

For instance, the price of crude palm oil is high because there has not been enough manpower to harvest the fresh fruit bunches. The pandemic crippled the mobility of foreign workers, who are the main source of labour in countries such as Malaysia.

Another reason for the inflation is that the global financial system is flush with cash, thanks in part to the efforts of governments to keep their economies afloat with various stimulus packages during the two years of the pandemic. From the US to South Korea and Australia, governments embarked on several schemes to put money directly into the hands of individuals and businesses.

In Malaysia, there were moratoriums on bank loans and the government allowed unprecedented withdrawals from the Employees Provident Fund (EPF) that surpassed RM101 billion. The government has allowed further withdrawals from the provident fund.

However, fears of the virus curtailing the global supply chain are easing off quickly. Road, air and sea transport services are all being restored to pre-pandemic levels. Ports are not as congested as before while airlines are increasing the frequency of flights.

The prices of commodities such as crude palm oil have started to come off their highs. The US is opening its reserves of crude oil to bring down the price of the commodity.

The market forces of supply and demand will tame the rising prices of goods and services.

Governments have also started to scale back on their stimulus schemes that pumped money into the economy. Leading the pack is the Fed, which has stopped its bond buying programme that effectively injects money into the system.

The inflation today invites a comparison with what happened post-World War II, according to Guggenheim global chief investment officer Scott Minerd. In a note, he stated that inflation blew up from 3.1% in June 1946 to 20.1% nine months later, owing to pent-up demand, a high level of savings and supply chain disruptions. Also, the Fed expanded its balance sheet from US$6.2 billion in 1942 to RM24.5 billion in 1945.

The inflation ended when the supply chain was restored and restrictions were imposed on extending credit to unproductive sectors. According to Minerd, the Fed did not mention anything about interest rate hikes.

Bank Negara Malaysia did not follow in the footsteps of the Fed to raise interest rates to curb inflation, which is a good move. This is because the inflation seen today is not caused by excessive demand but more by supply chain disruptions and excessive credit extended to the system.

Any interest rate hike will not be good for Malaysia’s fragile economy, which is still recovering from the pandemic. Malaysia had a recession in 2020 and last year’s rebound of 3.1% in economic growth is not inspiring. This year, the economy is expected to expand up to 6.3% but nobody can tell for sure.

For instance, China, the biggest economy in Asia, is still having spates of lockdowns and there is no end in sight to the Ukraine war. Both developments can hamper the growth of Malaysia’s economy.

The answer to the current inflation is to let market forces determine the prices of goods and services as the supply chain disruption is rectified. Curbing credit to unproductive sectors would be a good option to slow down demand.

A year from now, inflation could be back to its docile self.

Raising interest rates pre-emptively would bring about more harm to Malaysia’s fragile economy.

M Shanmugam is a contributing editor at The Edge

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