Financial Markets and Institutions (2-downloads)

The Yield Curve as a Forecasting Tool for Inflation

and the Business Cycle

Because the yield curve contains information about

future expected interest rates, it should also have the

capacity to help forecast inflation and real output fluc-

tuations. To see why, recall from Chapter 4 that rising

interest rates are associated with economic booms

and falling interest rates with recessions. When the

yield curve is either flat or downward-sloping, it sug-

gests that future short-term interest rates are expected 

to fall and, therefore, that the economy is more likely to

enter a recession. Indeed, the yield curve is found to

be an accurate predictor of the business cycle.

a

In Chapter 3, we also learned that a nominal

interest rate is composed of a real interest rate and

expected inflation, implying that the yield curve con-

tains information about both the future path of nomi-

nal interest rates and future inflation. A steep yield

curve predicts a future increase in inflation, while a

flat or downward-sloping yield curve forecasts a

future decline in inflation.

b

The ability of the yield curve to forecast business

cycles and inflation is one reason why the slope of

the yield curve is part of the toolkit of many eco-

nomic forecasters and is often viewed as a useful

indicator of the stance of monetary policy, with a

steep yield curve indicating loose policy and a flat or

downward-sloping yield curve indicating tight policy.

b

Frederic S. Mishkin, “What Does the Term Structure Tell Us About

Future Inflation?” 

Journal of Monetary Economics 25 (January

1990): 77–95; and Frederic S. Mishkin, “The Information in the

Longer-Maturity Term Structure About Future Inflation,” 

Quarterly

Journal of Economics 55 (August 1990): 815–828.

a

For example, see Arturo Estrella and Frederic S. Mishkin,

“Predicting U.S. Recessions: Financial Variables as Leading

Indicators,”

Review of Economics and Statistics, 80 (February

1998): 45–61.

C A S E