Economist’s View reported last week on a letter from Alan Greenspan that addressed some questions about monetary policy posed for the Fed Chair by Representative Jim Saxton (R-NJ). I was particularly interested in Greenspan’s explanation of why he is not concerned about the seemingly bearish connotations of the slope of the yield curve.
Although the slope of the yield curve remains an important financial indicator, it needs to be interpreted carefully. In particular, a flattening of the yield curve is a not a foolproof indicator of future weakness. For example, the yield curve narrowed sharply over the period 1992-1994 even as the economy was entering the longest sustained expansion of the postwar period.
Three basic factors affect the slope of the yield-curve–the current level of the real federal funds rate relative to the long-run level, the level of near-term inflation expectations relative to expected inflation at longer horizons, and the level of the near-term risk premiums relative to risk premiums at longer horizons.
Statistical analysis indicates that the first factor–the gap between the current and long-run levels of the real federal funds rate–is a key component from which the yield curve slope derives much of its predictive power for future GDP growth. When the level of the real federal funds rate is pushed well below its long-run level, economic stimulus is imparted and the yield curve steepens. The economic stimulus influences output growth with a lag; as a result, the steepening of the yield curve in this scenario is a predictor, albeit not the cause of, stronger economic activity ahead. Conversely, when the level of the real federal funds rate is pushed above its long-run level, economic restraint is imparted and the yield curve flattens. Once again, the economic restraint influences output growth with a lag, so the flattening (inversion) of the yield curve in this scenario would signal weaker economic growth ahead, but would not itself be the cause of the weakening.
The connection between future output growth and the other two factors affecting the slope of the yield curve–the gap between near-term and long-term inflation expectations and the difference between near-term and long-term risk premiums–is far less certain and likely to depend on economic circumstances.
I had the impression from these remarks that Greenspan was suggesting that the recent flattening of the yield curve may be a reflection of changes in inflation expectations or risk premiums and therefore not a source of concern. I disagree, by the way, with Greenspan’s assertion that changes in the risk premium are not predictive of future changes in real economic activity. Evidence detailed in an article by Dong Heon Kim and me published in the "http://dss.ucsd.edu/~jhamilto/kim.pdf">Journal of Money, Credit, and Banking showed that the term premium is indeed an important part of the historical relation. But putting this issue aside, I was curious to see what Greenspan was referring to in terms of the slope of the real yield curve.
The dashed red line in the figure at the right plots the yields on inflation-indexed securities of different maturities as they stood on June 15, 2004 (data from FRED). The real yield curve then exhibited the same upward slope as did the nominal yield curve at that time (e.g., here). As of this week, however, the real yield curve (solid blue line) is another story. The TIPS maturing 1 year from January is currently yielding 2.37%, a higher yield than that offered by TIPS of even the longest maturity. If Greenspan is right and it’s the slope of the real yield curve that really matters, then we’ve already reached an inversion.
Perhaps Greenspan is looking not at the TIPS yields but rather at the nominal fed funds rate minus expected inflation. What fed funds rate is likely to prevail over the next year? Fed funds futures seem to reflect an assumption that we’ll be at 4.75% by March. Inflation as measured by the median CPI, which I prefer to use for purposes of forecasting the future CPI, has been coming in steadily at a 2.3% annual inflation rate for quite a while, though it ticked up to 2.4% for the 12 months ended November 2005. If we take 4.75 minus 2.4, we get 2.35, almost exactly the 2.37% yield on the inflation-indexed Treasury maturing January 2007, and again, higher than the yield on inflation-indexed securities of longer maturities.
The inversion of the real yield curve seems to have already arrived.