May 27 (Bloomberg) -- Curves are in, in more ways than one.

Fashion designers are being forced to consider women's preferences for a more ample bust, be it naturally endowed or augmented.

In financial markets, curves are in as well; just not in the sense of in vogue. The yield curve, or the pictorial representation of the yields on Treasury securities across the maturity spectrum, has come in, or narrowed, to the point that it's creating a source of consternation for analysts and investors.

The spread between the overnight federal funds rate and the 10-year Treasury note rate stands at 112 basis points, down from a peak of 387 basis points in June 2004, when the funds rate was still at 1 percent.

The current positive spread is not contractionary; it's less stimulative than it was a year ago. With every indication that the Fed plans to proceed with its agenda of rate increases and every sign that long rates aren't going to budge in response (at least not higher), it's possible the curve could invert before too long.

An inverted yield curve, with short rates higher than long rates, is typically a harbinger of recession. Historically, the central bank raises short-term rates aggressively to constrain inflation, crimping growth in the process.

This Time Is Different?

Not this time. Reported inflation is tame, and the Federal Reserve's mission is to normalize short-term rates so as not to over-stimulate the economy. With one eye on the recent acceleration in various measures of inflation, Fed officials aren't contemplating implementing a contractionary monetary policy.

So what are we to make of the dramatic flattening of the yield curve? What is the message?

The yield curve is a simple construct that's widely misunderstood. Economists invoke it when it supports their forecast and dismiss it when it doesn't.

In the past few weeks, I've read or heard the following comments about the flattening yield curve:

A flatter yield curve means the Fed will have to raise short- term rates more;

A flat yield curve usually occurs when short and long rates are higher. Rates are low now, so the flatter curve doesn't matter;

A flat/inverted yield curve doesn't mean what it used to mean.

Inspiration

Such statements inspired me to craft a primer on the yield curve. For the purposes of this discussion, the yield curve will connote the spread between the overnight federal funds rate and 10-year Treasury note yield.

1. What's so special about two yields among thousands? What imbues them with such power and omniscience?

What's special is the information provided by the interaction between the two rates: one set by the central bank, the other by the market. While long rates are influenced by short rates -- the current short rate and its expected trajectory -- they're also affected by real activity and inflation expectations, not to mention a myriad of political and psychological considerations. The long rate is a window into the stance of policy.

2. My windows need washing. What do you mean by the interaction between them?

Consider a world where there is no central bank. When the demand for credit increases, the price of credit, or interest rate, will rise.

We have a central bank, as do most countries. Most of them use an overnight or other short-term rate as a policy tool. The monetary authority provides whatever reserves the banking system demands to achieve its target rate.

If the central bank is holding the short rate steady, and market rates are rising, it's a pretty good indication that the overnight rate is too low.

Why? Because that rate would be rising too were it not for the Fed's injection of reserves. In other words, the demand for credit is rising faster than the Fed can supply it.

3. Who figured this stuff out?

The theory behind the yield curve's role in anticipating economic growth and inflation can be traced back to the late Swedish economist Knut Wicksell (1851-1926). Wicksell argued that when the rate at which banks lend is below the rate of return on capital, which he called the natural rate of interest, prices would rise. When the bank rate exceeds the natural rate, prices would fall.

4. How do I know what the natural rate of interest is?

You don't. It's unobservable. Which is why the interaction between the two rates provides more information than the absolute level of both rates.

Think of the long rate as a check on the central bank. If policy is too easy or too tight, it will send up a flare.

5. Now I'm really confused. How can falling long rates be a negative? Isn't there more incentive to borrow at 5 percent than 6 percent?

Yes. And that's one part of the story. If you only looked at the level of long-term rates, the Great Depression should have been the Great Boom, and Japan's lost decade should have been Paradise Regained.

In both cases, low long-term rates were a symptom of weak economic growth, not a cause of stronger growth in the future.

During the Great Depression, the Fed let the money supply contract by one-third. There was no demand for credit even at a rock-bottom price.

6. Low mortgage rates have created a boom in housing. How can you say a flatter yield curve is less stimulative? Don't you read the papers?

Yes, I read them. Ceteris paribus, declining mortgage rates make home ownership more affordable. In the micro world of housing, credit demand is strong.

For the U.S. economy overall, there are more lenders (savers) at any given rate than there were before. Whether it's Asian central banks or private investors wanting a risk-free investment, more people are choosing to save in dollars, which is pushing down long-term rates.

7. So how can that be bad?

It's bad -- or at this point, less good -- because there's less incentive for commercial banks to increase the money supply. The steeper the yield curve, the more incentive there is to borrow from the Fed at the overnight rate and lend money to the private sector or Uncle Sam (buy Treasuries) at a higher rate.

It's no surprise that money supply growth has slowed in response to a flatter yield curve. The money supply has gone out of fashion, but I'm an old codger.

8. You mean there's more to the yield curve than the difference between two points?

Yes. But if you can grasp the fundamentals, you'll be way ahead of the curve -- I mean, ahead of most investment professionals.

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

Last Updated: May 27, 2005 00:17 EDT