The Yield Curve: The Long and Short of It
VICTOR A. CANTO AND ARTHUR B. LAFFER
Of late, analysts have busied themselves discussing the significance of an inverted yield curve. For the first time since 1982, the yield curve is literally on the verge of inverting. As it is told in the ancient book, when the yield curve inverts, a downturn follows.
To determine whether any systematic patterns can be uncovered and, specifically, whether there is any validity to the claim that inverted yield curves are precursors of recessions, we have chosen to examine the historical record of the United States during this century. For the purposes of this paper, the yield curve is said to be inverted when the short end of the yield curve (the three-month yield) exceeds the long end yields on bonds of 20 or 30 years. Since 1920, the short end of the yield curve has exceeded the long end of the curve in 10 instances (Figure 6.1). The length of the inversions ranged from one month to 24 months, with an average duration of 14.5 months (Table 6.1).
Nominal interest rates on government securities reflect market participants' joint forecasts of inflation and real interest rates over the maturity length of the security in question. In turn, the slope of the yield curve reflects the market's forecasts of joint changes in inflation rates and real interest rate expectations.
An inversion in the yield curve indicates that the market believes nominal yields in the future will decline relative to the present. Such a change in expecta-