By Howard Schneider and Ann Saphir
LITTLE ROCK, Ark./MCALLEN, Texas (Reuters) - Two Federal Reserve policymakers urged caution in raising interest rates on Friday, saying that the flattening of the yield curve was a signal that the central bank should proceed slowly.
The Fed is likely to raise interest rates when it meets in December and the current economic projections of rate setters indicate that it will hike three times in 2018.
New projections will come from Fed officials at their December 12-13 meeting, which could indicate whether concerns over the yield curve and a related debate over weak inflation have started to shake confidence in the 2018 projections.
The shallow slope of the yield curve - the spread between 2- and 10-year notes is currently 58 basis points, near the flattest in a decade - and whether it could invert, a signal of a possible economic recession, have triggered doubts in financial markets over the Fed's rate rise plans.
St. Louis Fed President James Bullard warned on Friday of a key "bearish signal" emerging for the economy if the Fed continues raising interest rates as fast as policymakers currently intend, and called on his colleagues to move more cautiously in the drive to more normal monetary policy.
If investors believe the Fed's actions will cause the economy to slow, and yields to fall, they may buy more longer-dated paper to lock in current yields, rather than take the risk of continually rolling over shorter-dated debt where the yields they earn are declining.
Higher demand for the longer-dated paper pushes prices up and yields, which move in the opposite direction, down, causing the curve to flatten.
A flattening curve can have a pernicious effect by making it less profitable for banks, which typically borrow short and lend long, to make loans.
Modern-day recessions in the United States have always been preceded by an inversion in the yield curve, but not every inversion has been followed by a recession, though it does generally signal economic risk.
Dallas Federal Reserve Bank President Robert Kaplan also voiced his concerns over the flattening curve, saying that it showed any removal of monetary accommodation "is going to have to be done patiently and gradually."
Bullard said that as it stands, within a year, short-term interest rates, pushed higher by Fed action, may move above long-term interest rates - an "inversion" of the yield curve.
CAUTION AROUND THE CURVES
It is unlikely that long-term rates will move higher on their own to keep pace with the Fed's moves on short-term rates, he said, which he felt should make the Fed slow down. The Fed has little influence over longer-term rates.
"The simplest way to avoid yield curve inversion in the near term is for policymakers to be cautious in raising the policy rate," Bullard said in a presentation to the Arkansas Economic Development Institute.
"There is a material risk...if the (Federal Open Market Committee) continues on its present course," Bullard said. Inversion "is a naturally bearish signal...This deserves market and policymaker attention."
Weak inflation has led to division among policymakers over whether they should slow the pace of rate hikes until it is clear that prices are going to recover.
Expected inflation is a key component of long-term bond prices since investors would want securities to hold value on an inflation-adjusted or "real" basis over time. That inflation weakness is another reason the yield curve may flip from its normal slope, which compensates investors for the risk of holding longer-term securities with higher interest rates.
The yield curve is "not infallible" as a predictor of the economy, Bullard said, and some researchers have argued that it is losing its usefulness as an economic signal given the global decline in interest rates.
But Bullard said policymakers and investors "need to take the possibility of a yield curve inversion seriously."
(Reporting by Howard Schneider and Ann Saphir; Writing by David Chance; Editing by Andrea Ricci)