What does a flat yield curve tell us?

By: Chris Waller, University of Notre Dame

In a very interesting blog on this site, Manfred Neuman (08.12.2006 “Should 3.5% be enough?”) points out that the yield curve in Europe is now essentially flat. Manfred argues that this means the markets do not believe the ECB will continue raising rates to choke off inflation. The implication is that the ECB is not credible in its stated implication of reducing inflation within its target range. This is a rather damning statement if one thinks about it.

 

What does a flat yield curve mean? It means that short-maturity interest rates are essentially the same as interest rates on longer term maturities. The standard “rational expectations” theory of the yield curve predicts that long-term interest rates should be an average of current and future short-term rates (due to arbitrage opportunities). By this theory, an upward sloping yield curve would tell us that the market expects future short-term nominal interest rates to be higher than the current short rate. A downward sloping yield curve would suggest that future short rates will be lower than they are at present.

 

Now by the Fisher equation, the nominal interest is (approximately) the sum of the expected real return on an asset and the expected inflation rate. Thus, if inflation is expected to be higher in the future than at present, then short-term nominal interest rates will also be higher in the future. This says the yield curve should be upward sloping (or at least become steeper) if inflation is expected to get ‘out of control’. On the other hand, if the current inflation rate is a good predictor of future inflation rates, then the market will expect today’s short-term interest rate to prevail into the future. In this situation, the yield curve should be relatively flat.

 

A similar argument can be made regarding real interest rates. The ECB can typically push up real interest rates in the short run to choke off spending and inflationary pressures. Thus, if the market believes the ECB will attack inflation into the near future then it will expect future real interest rates to be higher as well. This means the yield curve will tend to maintain its current slope. But if the market believes the ECB will not be vigilant in its fight against inflation, then future real interest rates will be expected to be lower and the yield curve will flatten out (or even become negatively sloped). This is essentially Manfred Neumann’s argument.

 

So how do we interpret a flat yield curve in terms of the ECB’s credibility as an inflation fighter?

 

Explanation 1: From the expected inflation point of view, a flat yield curve means that the market does not believe inflation will change much from what it currently is. That’s good news if inflation is in the ECB’s target range. Otherwise, the markets think inflation is just going to stay where it is, which at the current moment is substantially above the targeted 2%. Thus, the markets are not putting any weight on the ECB’s statements about fighting inflation. Is there any good news from the flat yield curve? Well, it suggests that the markets do not think inflation will increase substantially in the future relative to where it is. In short, they do not believe inflation is out of control. That is at least some good news.

 

Explanation 2: From the real interest rate point of view, the flat yield curve is consistent with Manfred’s viewpoint that no one finds future rate increases will be used to tame inflation. Consequently, ECB statements about reducing inflation are empty promises.

 

Explanation 3: If we combine the expected real rate effect with the expected inflation effect we get something like this: The market believes the ECB will raise short term rates in the future AND this will correspond to lower expected inflation in the future. If these two effects just cancel out, then the expected future nominal interest rate should stay the same. In this case, the ECB is credible about reducing inflation even though the yield curve is flat. I am sure this is what the ECB will tell you is happening.

 

For me, I am placing my bet on Explanation 1. Time will tell if I am to collect on that bet!

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