Recessions ; Interest rates ; Inflation (Finance)

Frederick T. Furlong

English

Research Papers in Economics

FABSF WEEKLY LETTER
March la, 1989
The Yield Curve and Recessions
Feb. 6, 1988
Feb. 7, 1989
,//------------________________________ 9
Percent
expects short-term interest rates to be higher in
the future, the yield on a lO-year Treasury note
will be higher than that available on a three-
month Treasury bill today, and the yield curve
will slope upward. Similarly, if the market ex-
pects short-term rates to be lower in the future,
the yield on the longer-term security will be
lower than that on the T-bill, and the yield curve
will slope downward (be inverted).
1955 1960 1965 1970 1975 1980 1985
Empirical regularity
Chart 2 shows why the current shape of the yield
curve. is drawing attention. Before each ofthe last
four recessions, the spread between the la-year
Treasury rate and the three-month Treasury rate
turned negative, indicating that the yield curve
was inverted. In the cases of the 1957 and 1960
recessions, the spread remained slightly positive,
although it narrowed considerably. Prior to those
two recessions, the yield curve was inverted for
maturities beyond one or two years, as in early
February 1989. The only time a recession did not
follow an inversion of the yield curve was in the
mid-1960s, and even then, real economic activity
slowed.
Chart 2
Nominal Interest Rate Differential
10-year T-note less 3-month T~bill
(Yield basis, quarterly average)
7
6
5
4
3
2
1
o
-1
-2
-3
r4'-.........4--T--."'i-.,....,."T""T""T""T""..-r-Fr--,4--T"+-..-.,....,.-r-i"...-'i"''r-r-.........~ - 4
Recession link
But why should the yield curve flatten and invert
just prior to cyclical peaks in the economy? His-
torically, the flattening and inversion of the yield
curve occurred when interest rates were rising
rapidly. During these periods, it is logical that
5
7
8
6
30
Percent
10
25 10 15 20
Years to Maturity
Chart 1
Treasury Yield Curve
Nominal Rates, Yield Basis
Over the past year, short-term interest rates have
risen sharply, while long-term interest rates have
moved very little. As a result, the yield curve has
flattened considerably. Chart 1 shows that in
early February, the slope of the Treasury yield
curve was only slightly positive out to maturities
of two years, and it was negative beyond two
years.
Is this reading of the "tea leaves" appropriate at
this time? Maybe not. In the current environment
of long-run disinflation, a flat yield curve does
not necessarily have the same implications for the
economy that it had in the past.
The yield curve
The yield curve depicts the term structure of
interest rates, that is, the relationship between
the yields on securities of comparable risk and
their terms to maturity. Under the so-called
"expectations" theory of the term structure of
interest rates, the return currently available on a
fixed-rate security that matures at the end of, say,
10 years should equal the"expected return from
investing in a consecutive series of short-term se-
curities over the same period. Thus, if the market
Some analysts think that the shape of today's
yield curve indicates that a recession is likely in
the near future. This view is based on the obser-
vation that the yield curve flattened or inverted
prior to each of the last six recessions.FRBSf
9
8
7
6
5
4
3
2
1988 1986 1984 1982 1980 1978
Source: Drexel, Burnham, Lambert
The Chart shows that inflation expectations for
one year ahead rose noticeably in 1988, follow-
ing a trend that began in the latter part of 1986.
Overall, one-year ahead inflation expectations
rose by more than 3/4 percentage point last year.
At the same time, however, the outlook for infla-
tion over the longer run continued to improve in
1988, according to the DBL survey. On average,
survey participants' expectations for inflation
over a lO-year horizon fell by Y2 percentage
point.
The question, then, is what are the implications
of these changes in inflation expectations? If the
steady decline in longer-term expectations is due
to a belief that a recession is imminent, then it
seems likely that expectations ofthe future level
of longer-term real interest rates ought to show a
decline as well.
Chart 3 plots quarterly averages of the survey
results that were available in each quarter
through December 1988, the last month for
which survey results were available.
Using DBL survey data to represent the inflation
premia in short-term and long-term nominal in-
terest rates, it is possible to derive estimates of
the real interest rates on Treasury securities with
maturities ofone, five, and ten years. In ChartA,
these estimates have been used to construct real
yield curves. These yield curves show that, from
January to December 1988, the real interest rate
on lO-year securities rose by nearly as much as
that on theone-year securities. Thus, the move-
mentin real rates did not have much to do with
the flattening of the nominal yield curve over the
Chart 3
Expected Inflation
In the past, market participants could expect
interest rates to behave in this fashion around
cyclical turning points for two reasons. First,
recessions tended toslow economic activity and
reduce the demand for credit, causing real, or
inflation-adjusted,interest rates to faHfrom their
cyclical peaks. Second, recessions also tended to
slow the rate of inflation, causing the inflation
premium in nominal interest rates to fall.
The. inflationary environmentofthe1970s and
early 1980s can help toexplaipwhy the yield
curvetended to. invert only when recessions (or
at least economic slowdowns) seemed imminent.
During this period, theoverall trendin nominal
interest rates was upward, largely because inves-
torswere requiring ever higher premia to com-
pensate for accelerating inflation. Recessions
were the only thing that seemed even temporar-
ily toslowthe price spiral and the rise in
nominal interest rates.
Onesource of information on inflation expecta-
tions is a survey of 190 institutional investment
decision makers, conducted by Richard HOey
and published by Drexel Burnham Lambert
(referred to as the DBL survey hereafter). That
survey provides consen"sus inflation expectations
for periods ·of one, five,and ten years ahead:
many observers would come to expect the high
and rising level of interest rates to push the econ-
omy into a recession, which subsequentlYvvould
cause interest rates to decline. And because they
were expecting interest rates to be lower in the
future, the yield curve would flatten or invert at
these times, in keeping with the expectations
theoryofthe term structureofinterest rates.
VVhat about today?
Whether thecurrentflattening of the yield curve
is a harbinger of a recession depends on whythe
market might expectshort-tertninterest rates to
fall in the future. In the past, investors likely did
notexpect future rates to fall unless a recession
intervened to dampen the inflationary spiral. But
thedisinflationary environment of the 1980s is
very different from the past. In fact, much of the
current rotation in the nominal yield curve is due
to shifts in shorHun and long-run inflation ex-
pectations that are not necessarily due to a sig-
nificant change in the perceived probability of a
recession.past year. Instead, the shift in the yield curve, at
least in the one-year to the 10-year range, mainly
reflects changes in inflation expectations.
that decision makers expect lower inflation and
lower interest rates to come as a result of a
recession.
Jan. 1988
2
This argument seems even more reasonable
when we see that decision makers' outlooks for
inflation in the short run and in the long run are
not very far apart. Nor are their long-run expec-
tations far from actual inflation last year, which
was 4Y2 percent, as measured by the GNP fixed-
weight price index. Thus, it appears that decision
makers are not expecting any major changes in
the fundamental factors affecting inflation (such
as the pace of economic activity) in the near
future, even though they do expect a small, tem-
porary rise in inflation this year.
4
Percent
5
-----J3
Dec. 1988
--------------------- --- --- --- ---
Chart 4
Treasury Yield Curve
Real Rates
'0
Years to Maturity
In fact, in the current economic environment, a
steady decline in long-run inflation expectations
apart from a similar trend in the real rate is not
an unreasonable proposition. Partly because of
the shift in monetary policy that took place in the
early 1980s, the u.s. has moved into an environ-
ment of lower inflation. It seems reasonable that
the steady decline in expectations reflects fi nan-
cial decision makers' gradual acceptance of this
new environment.
In a sense, then, the recent decline in inflation
expectations is a lagged response to a shift in
monetary policy in the early 1980s, and not
necessarily indicative of a shift in attitudes con-
cerning the likelihood of recession. That is, it is
possible to explain the recent flattening of the
yieldcurve without resorting to the argument
Rethinking the link
In the past, a marked flattening or an inversion
of the yield curve generally signaled an impend-
ing recession. This time around, however, the
slope of the yield curve has flattened under con-
ditions that certainly did not exist in the 1970s
and early 1980s. What is different now is that
inflation expectations have been declining for
some time, apparently in (lagged) response to a
policy shift that began in the early 1980s. There-
fore, in the current economic environment, we
cannot be sure that a flattening or an inversion of
the yield curve has the same meaning as in the
past. This observation does not tell us whether a
recession is more or less likely now, only that we
need to be cautious when we use the nominal
yield curve as a leading indicator of peaks in the
business cycle.
Frederick T. Furlong
Research Officer
Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of
San Francisco, or of the Board of Governors of theFederal Reserve System.
Editorial comments may be addressed to the editor (Barbara Bennett) or to the author.... Free copies of Federal Reserve
publications can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702,
San Francisco 94120. Phone (415) 974-2246.Research Department
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The yield curve and recessions

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The yield curve and recessions

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