May 12 (Bloomberg) -- Like clockwork, the alarm bells are going off as long-term Treasury yields start their inevitable climb.

“Rising Government Bond Yields Frustrate Central Banks,” trumpets yesterday’s Wall Street Journal.

“Rising bond yields present fresh Fed challenge,” according to the April 29 edition of the Financial Times.

It’s a funny thing about long-term interest rates. They’re pro-cyclical. They tend to rise when the economy is doing well, when demand for credit is strong. They fall when the economy is in the tank, and the private sector isn’t much interested in investing and spending.

If there’s a way to accommodate the increased demand for credit that goes hand in hand with recovery without pushing up the price, no one has figured it out just yet.

For a time, the federal government’s increased borrowing needs, both current and expected, were being met by more-than- willing lenders. The flight-to-quality into Treasuries drove yields to historic lows, with the benchmark 10-year note bottoming at 2.04 percent in December.

Last Friday, the 10-year yield touched 3.38 percent as a proliferation of green shoots calmed investor fears of an endless dark winter.

That’s not good news for the Treasury, which has to pay interest on the rapidly expanding debt. For the Fed, however, rising yields are a sign its medicine is working.

Good News

Unlike market-determined long-term rates, the overnight interbank lending rate is set by the central bank. Other short- term rates gear off the fed funds rate, with an added premium for perceived risk.

Treasury bill yields actually went negative for a spell in December, right around the time the Fed slashed the funds rate to a range of zero percent to 0.25 percent. In other words, investors were willing to park money with the government for three or six months and receive less when the bills matured. Even the mattress can top that.

Long-term rates are the sum of the current and expected future short-term rates. With short rates virtually at zero, what would falling long rates say about prospects for the U.S. economy? Not much, I’m afraid.

After throwing so much monetary and fiscal stimulus at the economy, policy makers should be grateful for a sign things are working.

If this sounds familiar, it is. I probably write about the yield curve more than any single subject. I both understand and believe in it.

Too Simple to Understand

The yield curve, or spread, has several things going for it:

First, it’s a leading economic indicator, officially added to the index designed to predict the economy’s ebbs and flows in 1996. It was a leader well before that, even though it was unofficial.

Second, what you see is what you get. The spread is never revised, always available and in no way proprietary.

Third, and most curious, the majority of economists don’t get it. They see rising bond yields in isolation -- without paying attention to what that price-setter, the Fed, is doing at the front end of the curve.

It’s the juxtaposition of short and long rates, not their level, that conveys information about monetary policy.

In a July 2008 working paper, San Francisco Fed economists Glenn Rudebusch and John Williams examined the tendency for professional forecasters to ignore the spread. They compared the forecasts provided by the Survey of Professional Forecasters (SPF) to that generated by a simple, real-time model based on the yield spread.

Guess who won? And it wasn’t even close.

Slow Learners

Why, in the face of the yield curve’s superior track record, would economists choose to ignore it?

“If you think monetary policy matters, you should care about the spread,” says Jim Glassman, senior economist at JPMorgan Chase & Co. With the Fed’s “ability to anchor short- term rates at artificial levels, the spread is a way of looking at the stance of monetary policy.”

Rudebusch and Williams found forecasters to be slow learners when it came to incorporating the “usefulness of the yield spread for forecasting recessions,” they say in “Forecasting Recessions: The Puzzle of the Enduring Power of the Yield Curve.”

Even when economists are fully apprised of the yield curve’s “significant real-time predictive power for distinguishing between expansions and contractions several quarters out,” they find a way to explain away the message.

What, Not Why

“Signals from the yield curve have often been dismissed because of supposed changes in the economy or special factors influencing interest rates,” Rudebusch and Williams write.

In other words, this time is different.

Remember the cries that went out when the yield curve inverted in the middle of 2006 and remained that way through early 2008? China was buying our bonds, pushing down long-term rates. It was a conundrum, but it was dismissed.

Therein lies the beauty of the spread. The why matters less than the what. It is what it is.

The steepening yield curve is not going to nip the recovery in the bud. (These warnings are sure to follow.) To the contrary, it’s a sign that things are improving.

The yield curve was almost vertical in the early 1990s, another period where bank balance sheets were impaired. It took a steep curve for a long time to heal the banks, which borrow short and lend long when they aren’t getting into trouble with newfangled products.

If the Fed wants to worry about something, it should forget long-term interest rates. They will take care of themselves.

Policy makers have much bigger concerns, namely the ability, and political wherewithal, to shrink the Fed’s $2 trillion balance sheet when the time comes.

And when will that be? The yield curve will provide valuable input, assuming anyone is listening.

(Caroline Baum, author of “Just What I Said,” is a Bloomberg News columnist. The opinions expressed are her own.)

To contact the writer of this column: Caroline Baum in New York at cabaum@bloomberg.net.

Last Updated: May 12, 2009 00:01 EDT