Why the yield curve matters

Alan Greenspan and the Conference Board could both be wrong, according to a paper in the latest Economic Journal.
Mr Greenspan recently told the Joint Economic Committee that the yield curve is not a foolproof indicator of a downturn (pdf). And the Conference Board last week rejigged its index of leading indicators to give the curve less prominence.
If they're right, we shouldn't worry that the current flatness in the curve points to a sharp slowdown.
However a paper by Arturo Estrella (pdf) shows that there are good reasons why the yield curve should predict economic activity. If he's right, we can add a fourth reason to James D. Hamilton's list of reasons why the Fed shouldn't raise rates aggressively.
Mr Estrella shows that the ability of the yield curve to predict output is the natural result of  a standard macroeconomic model  with rational expectations and reasonable monetary policy reactions. Under a Taylor rule - whereby short rates are determined by the output gap and inflation alone, the yield curve should be a powerful forecaster of output. And if monetary policy is used solely to stabilize output, shows Mr Estrella, the yield curve will be the best possible forecaster of output.
The intuition here is that if everyone sees a recession coming, bond markets will anticipate lower short rates and lower future inflation, as the recession lowers inflation. That will drive long yields down more than short rates (as these do not fall in response to future inflation.) The result will be a yield curve inversion and a subsequent recession.
However, under a regime of strict inflation targeting, bond markets know what future inflation will be, so long yields won't move so much. In this regime, the yield curve will be a worse predictor of output than in a regime where monetary policy is used to stabilize output. This, shows Mr Estrella, is why the yield curve has become a less good predictor of output since 1987 - because since then, the Fed has given more weight to inflation targeting relative to output stabilization.
This summary does horrible violence to the subtlety of  Mr Estrella's paper. The question it helps us answer is: how can the yield curve now not be pointing to a slowdown? Mr Estrella's paper suggests three possibilities:
1. The Fed is engaging in stricter inflation targeting (and less output targeting) than it has in the past.
2. Expectations are not rational, in some say.
3. The term premium is falling for rational reasons; Mr Estrella abstracts from this issue.
Whatever your answer to this question, please don't invoke foreign official buying of US Treasuries because this has fallen off recently at the same time as the curve has flattened; in the 12 months to May, official buying of Treasuries was $117bn, compared to $193.7bn in the 12 months to May 2004.

Comments

[Rob Read]

Your assuming that a recession will lower inflation.

[chris]

Yes Rob - this assumption is what I meant by a "standard macroeconomic model." It's a variant of the old Phillips curve, whereby the output gap leads to changes in inflation.
Personally, I think this is questionable in the short-term. There are loads of reasons why inflation would be slow to fall in a recession, and might even rise - counter-cyclical mark-ups and the like - but it would be soooo 1980s to rehearse them. It seems consistent with the data and with short-term price stickiness that, in the longer-run, recessions do indeed reduce inflation. And this is what matters for longer-dated bonds. So this story still holds, I think.

[Rob Read]

In a recession is caused by protectionism i.e. the ending of the massive Chinese deflationary effect that was cancelling out the huge inflationary pressure caused by the large Adiabatic expansion of money. Then the result will be massive inflation.

Of course, Chinese economic growth is causing inflation in commodities, but due to low wages in China, deflation in more-finished goods.

[Mark T]

Greenspan's point was that the long standing relationship between the yield curve and subsequent output has become increasingly weak (see recent work done by Fed Bank of Cleveland for example)and yet the imbedded assumption in most work is that the long term relationship is stationary - indeed in the ever optimistic (for them) bond markets it is almost an article of faith. While not evoking the foreign central banks reasoning, there does seem to be a demand for long term "risk free" investments from overseas investors at a rate below that dictated by models of the US economy, as well as an ongoing carry trade that appears to persist until the curve is almost entirely flat.