Long term and short term interest rates

Long-term interest rates are higher than short-term rates, which is usually a sign that the economy will expand.

Not this time, I’m afraid. It’s all about the zero lower bound.

The reason for the historical relationship between the slope of the yield curve and the economy’s performance is that the long-term rate is, in effect, a prediction of future short-term rates. If investors expect the economy to contract, they also expect the Fed to cut rates, which tends to make the yield curve negatively sloped. If they expect the economy to expand, they expect the Fed to raise rates, making the yield curve positively sloped.

But here’s the thing: the Fed can’t cut rates from here, because they’re already zero. It can, however, raise rates. So the long-term rate has to be above the short-term rate, because under current conditions it’s like an option price: short rates might move up, but they can’t go down.

Indeed, if we look at Japan we find that the yield curve was positively sloped all the way through the lost decade. In 1999-2000, with the zero interest rate policy in effect, long rates averaged about 1.75 percent, not too far below current rates in the United States.

So sad to say, the yield curve doesn’t offer any comfort. It’s only telling us what we already know: that conventional monetary policy has literally hit bottom.





The Yield Curve,



This difference, the slope of the yield curve, has achieved some notoriety as a simple forecaster of economic growth. The rule of thumb is that an inverted yield curve (short rates above long rates) indicates a recession in about a year. More generally, a flat curve indicates weak growth, and conversely, a steep curve indicates strong growth. One measure of slope, the spread between 10-year Treasury bonds and 3-month Treasury bills, bears out this relation, particularly when real GDP growth is lagged a year to line up growth with the spread that predicts it.





While such an approach predicts when growth is above or below average, it does not do so well in predicting the actual number, especially in the case of recessions. Thus, it is sometimes preferable to focus on using the yield curve to predict a discrete event: whether or not the economy is in recession.