The Inscrutable Yield Curve

Is it really signaling a slowdown?

Keep your eye on the yield curve--the spread between the interest rates of debt securities with different maturities. One of the most sensitive economic barometers, its behavior in recent months is stirring a hot debate among economists.

In assessing the yield curve's implications, the general rule is that an upwardly sloping curve (the usual condition, in which yields are higher as maturities lengthen) points to an expanding economy, while a flat or downward-sloping curve means a slowing or contracting economy. And changes in the slope signal changes in the future pace of economic activity.

What's currently causing a stir is that the yield curve has flattened dramatically in recent months--and for unusual reasons. Indeed, since BUSINESS WEEK first discussed this development a few weeks ago (BW--Nov. 17), the yield gap between 10-year and 3-month Treasury securities, which had narrowed since early April from 1.64 to only 0.73 of a percentage point, has plunged even more, to 0.56 of a percentage point.

Ordinarily, such a flattening of the yield curve would foreshadow a sharp slowdown in growth, and that in fact is what many experts predict. The curve's "unambiguous message" is that less exuberant activity lies ahead, says Bruce Steinberg of Merrill Lynch & Co., who sees growth slowing to 2.5% in 1998, with "the risks on the downside."

Economist Joseph Carson of Deutsche Morgan Grenfell, however, notes that the current narrowing of spreads is atypical: Usually, it is the Federal Reserve that sets the process in motion by pushing up short-term interest rates closer to long rates. But this time around, short rates have been relatively stable since March, while long rates have fallen in apparent response to investors' expectations that growth would slow and inflation would stay low.

"History shows that when the yield curve flattens in response to investors' expectations, rather than to monetary tightening, it loses accuracy as a leading indicator," says Carson.

Noting that the economy has grown by about 4% over the past year, Carson's colleague Joseph LaVorgna points out that the economy slowed from such a pace only six times since 1962, and in each case the Fed pushed up rates significantly. Thus, Carson and LaVorgna think the economy will continue to expand briskly in coming quarters--until the Fed finally acts to slow things down.

Time may prove them right, but many economists are dubious. In a recent article in Business Economics, Robert D. Laurent of the Federal Reserve Bank of Chicago argues that short-term rates reflect the supply of credit, whereas long-term rates reflect demand. Thus, if long rates decline while short-term rates are steady, the implication is that a slowdown lies ahead.

It has happened before. In the second half of 1985 and early 1986, notes Laurent, when long-term rates fell sharply in the face of a stable federal funds rate, most economists were expecting buoyant growth ahead. Instead, first-quarter growth in 1986 came in at just 0.6% and the Fed had to lower rates four times in subsequent months to revive the flagging economy.

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