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Wednesday, December 28, 2005

Yield Curve Inversions When Expected Inflation is Low

I haven't known what to say about the briefly inverted yield curve because it does not alarm me as much as it does others. I guess the best way to put it is that it is like a noise in the dark. It's not a problem in and of itself, but it may signal trouble. It's something that catches your attention, and it's worth paying attention and checking to see if anything is wrong, but there's no certainty that trouble is near.

I am not worried. I believe there is a fundamental difference today versus recent decades. Up until now, I had no faith that monetary authorities were committed to fighting inflation first and foremost and I never would have dared risk a variable interest rate loan. Experience suggested that eventually inflation would return, or there was at least a substantial chance that it could return. Today I would be willing to bet, even for a decade or more, that inflation will remain in check and I would be willing to sign a variable rate contract to try and win that bet (this is not advice on mortgages as I am abstracting from lots of other differences in terms). Up until a year or so ago, I did not have such faith. But monetary authorities have convinced me they will not waiver in their commitment to price stability.

If I am not alone, if there has been a substantial change in long-run inflationary expectations regarding the risk of higher inflation, that flattens the "natural" yield curve. Due to liquidity concerns, long-term rates should still command a premium so the natural state is upward sloping, but I would argue it is fairly flat.

With a flattened "natural" yield curve, and variation around that natural state, it is more likely that an inversion will occur than in the past. But since the natural state of the yield curve is flatter than in the past, an inversion does not represent as much of a deviation from the natural state as it once did and hence does not bring as much consternation with it, at least from me.

    Posted by on Wednesday, December 28, 2005 at 09:38 AM in Economics | Permalink  TrackBack (2)  Comments (14)


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