Yield Curve

            Economists often use complex mathematical models to forecast the path of the US economy and the likelihood of recession. But simpler indicators such as interest rates, stock price indexes and monetary aggregates also contain information about future economic activity.

Currently, the yield curve is thought offer-valued information on expectations.  By developing the basis of such a belief, an understanding of the yield curve can emerge.  Evaluating the expectations content of the yield curve will show the positive and negative aspects of following the yield curve.  Some economists think the yield curve offers constructive information on expectations.

            The reason why economists believe the yield curve can offer valuable information on expectations is because before the last six recessions short-term interest rates rose above long-term rates producing a yield curve inversion (Mishkin).  This statistical anomaly has given rise to the notion that the yield curve can predict recessions.  Since the 1980s, research on the yield curve, mostly empirical, documents correlations rather than building theories to explain such correlations.  Because of this lack of theories, economists have not been able to come to a consensus on the yield curve. 

            By evaluating the expectations of the yield curve, positives and negatives of following the yield curve are established.  Normally, the most common yield curve is derived from the spread of the short-term rates less long-term yields.  Because this is what derives the yield curve, investor expectations can change the yield curve.  Future short-term interest rates depend on future demand; an increase in short-term interest rates by the Federal Reserve might lead to an economic slowdown. The expectations of future short-term interest rates are related to future real demand and to future inflation. This likely slowdown will start pushing future real rates downward, and flatten the yield curve.  Since investor expectations change the yield curve, the yield curve may be more forward-looking than other leading indicators. The yield curve should be included in policy deliberations. Due to the statistical nature of the yield curve, other measures of the economy must be used as well.  Discounting the yield curve completely would not indicate sound judgment.  By understanding what the yield curve is indicating, the policymakers can produce preemptive action to reduce or eliminate downturns in the economy. 

            As with other tools the Fed uses to maneuver the economy, the yield curve has positives and negatives. The Federal Reserve officials who think the yield curve offers valuable information are correct in their assumption.