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The flattening of the yield curve : causes and economic policy implications

Author

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  • M. Collin

    (National Bank of Belgium, Research Department)

Abstract

The article examines the flattening of the yield curve in the euro area since mid 2004, and that in the United States where a slight inversion has actually been apparent since mid 2006. Analysis has shown that, apart from the tightening of monetary policy, this phenomenon is due to a substantial reduction in the risk premium, and especially its real component. It also indicates that this contraction was caused mainly by strong demand for government bonds on the part of atypical investors, in particular, the Asian central banks and pension funds. In addition, the study revealed that the reliability of break-even inflation as an indicator of inflation expectations is not really affected by this flattening, since the reduction in the inflation risk premium made only a small contribution to the contraction of the overall risk premium. Conversely, the analysis indicates that the quality of the yield curve as an advanced indicator of the business cycle is affected by the contraction of the risk premium. Since the flattening of the yield curve is due to adjustment of the risk premium rather than revised interest rate expectations, the current behaviour of the yield curve does not signal a marked slowdown in economic activity. Since, the contraction of the risk premium corresponds to an easing of financial conditions, the monetary authorities need to exercise great vigilance in order to ensure price stability in the medium term. Vigilance is all the more necessary if the reduction in the risk premium is not due to changes in the macroeconomic fundamentals. In that case, there is also the risk of a possible upward adjustment to long-term interest rates. However, it should also be noted that the demand currently exhibited by atypical investors seems to be more structural than that generated by the “flight to quality” which lay at the root of the decline in the risk premium during the period 1997-1998. The risk premium reduction which occurred between June 2004 and June 2005 therefore appears to be more persistent than that seen between mid 1997 and the end of 1998.

Suggested Citation

  • M. Collin, 2007. "The flattening of the yield curve : causes and economic policy implications," Economic Review, National Bank of Belgium, issue i, pages 47-60, June.
    • Handle: RePEc:nbb:ecrart:y:2007:m:june:i:i:p:47-60
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    References listed on IDEAS

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    1. James H. Stock & Mark W. Watson, 2003. "Has the Business Cycle Changed and Why?," NBER Chapters, in: NBER Macroeconomics Annual 2002, Volume 17, pages 159-230, National Bureau of Economic Research, Inc.
    2. Ang, Andrew & Piazzesi, Monika & Wei, Min, 2006. "What does the yield curve tell us about GDP growth?," Journal of Econometrics, Elsevier, vol. 131(1-2), pages 359-403.
    3. Glenn D. Rudebusch & Tao Wu, 2008. "A Macro‐Finance Model of the Term Structure, Monetary Policy and the Economy," Economic Journal, Royal Economic Society, vol. 118(530), pages 906-926, July.
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    Keywords

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    JEL classification:

    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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