The predictive power of the yield curve has been at the forefront of recent economic
discussions in both the United States and Europe. New research by Arturo Estrella,
published in the July 2005 Economic Journal, explains why there are these empirical
relationships between real economic activity, inflation and the pattern of yields on bonds of
different maturities – and whether they are likely to persist under changing economic
conditions.
A large body of empirical evidence since the late 1980s documents a strong predictive
relationship between the slope of the yield curve – a line drawn through the effective
interest rates on government securities with different maturities – and future real economic
activity and inflation.
A normal yield curve gently slopes upwards with long-term rates higher than short-term
ones, reflecting expectations of positive economic growth and compensation for the higher
risks – including unexpected inflation – of investing for a longer period. A flat curve when all
maturities have similar yields or an inverted curve when long-term yields fall below shortterm
yields – as in the UK today – send signals of economic uncertainty and expectations
of slowdown or even recession.
The analysis in this study suggests that the interaction of monetary policy with some
features of the real economy gives rise to the predictive power of the yield curve. Though
precise numerical formulas may vary with changes in monetary policy or economic
parameters, the existence of some form of predictive power for both output and inflation is
robust.
In the United States, yield curve inversions and subsequent recessions have occurred hand
in hand since the 1960s. The start of a recession typically follows within a year of the low
point for the difference between 10-year and 3-month Treasury rates.
Recent experience shows that the empirical evidence is of more than historical interest. For
example, the National Bureau of Economic Research dated the start of the last recession in
the United States to March 2001, following a yield curve inversion that lasted over most of
the second half of 2000.
The empirical relationship between the yield curve and recessions appears quite robust in
the face of ostensibly important changes in the economic, financial, and monetary
environment since the 1980s.
The relationship is also evident in the international context: similar evidence has been
gathered for various European economies, as well as for Canada and Japan. Especially
strong are the results for Germany, the United States and Canada, whereas weaker results
are found in the case of Japan.
The research strategy of this article is to construct a model that is sufficiently general as to
incorporate the main relevant features of the economy, and yet simple enough to be solved
analytically so as to expose the key economic relationships. The model includes
components corresponding to the private sector of the economy, the monetary authority,
and the financial sector.
Although the analysis is mainly theoretical, the realism of the model is validated empirically
by estimating the behavioural equations using US data from 1962 to 2002. Estimates are
consistent with both the earlier evidence and the theoretical assumptions of the model.
Why does the yield curve predict output and inflation? The model suggests that monetary
policy is an important determinant of the predictive power and of the precise numerical form
of the predictive relationships. But other features of the real economy are also important.
In the case of inflation predictions, the relationship between economic slack and inflation
(the ‘Phillips curve’) plays an important role. In addition, if the monetary authority follows
specific goals such as targeting inflation or limiting output variability, the full structure of the
real sector of the economy becomes relevant in the predictive equations.
In general, though precise numerical formulas may vary with changes in monetary policy or
economic parameters, the model suggests that the existence of the predictive relationships
encountered in the empirical literature for both output and inflation is quite robust.
One interpretation of this result is that qualitative relationships – such as between a yield
curve inversion and a subsequent recession – should be fairly persistent, whereas precise
quantitative relationships – such as between the yield curve slope and the subsequent rate
of real GDP growth or the inflation rate – may vary over time.
ENDS
Notes for editors: ‘Why Does the Yield Curve Predict Output and Inflation?’ by Arturo
Estrella is published in the July 2005 issue of the Economic Journal.
Arturo Estrella is Senior Vice President in the Capital Markets Department of the Research
and Statistics Group at the Federal Reserve Bank of New York.
For further information: contact Arturo Estrella on +1-212-720-5874 (email:
Arturo.estrella@ny.frb.org); or RES Media Consultant Romesh Vaitilingam on 0117-983-
9770 or 07768-661095 (email: romesh@compuserve.com).