For many commentators, a change in the shape of the differential between the long-term interest rate and the short-term interest rate—i.e., the yield spread provides an indication of the likely direction of the economy in the months ahead. Thus, an increase in the yield spread raises the likelihood of a possible strengthening in economic activity in the months to come. Conversely, a decline in the yield spread is seen as indicative of a possible economic downturn ahead.
A popular explanation regarding the shape of the yield curve is provided by the expectations theory (ET). According to ET, expectations for an increase in the short-term interest rate sets in motion an upward sloping yield curve, while the expectation for a decline in the short-term interest rate sets the downward sloping yield curve.
In the ET framework, the average of the current and expected short-term rates determines the current long-term interest rate. Whenever investors anticipate economic expansion, they also form expectations that the central bank will raise short-term interest rates by lifting the policy interest rate.
To avoid capital losses, investors move their money from long-term to short-term securities. (A rise in interest rates will have a greater impact on the prices of long-term securities versus short-term securities). This shift will bid short-term securities prices up and lower their yields. For long-term securities, the shift of money away from them will depress their prices and raise their yields. Hence, there is a decline in short-term yields and an increase in long-term yields—so an upward sloping yield curve emerges.
Conversely, mainstream economists believe that whenever investors expect an economic slowdown or a recession, they also expect the central bank will lower short-term interest rates by lowering the policy interest rate. Consequently, investors will shift their money from short-term to long-term securities, and the sale of short-term assets results in lower securities prices and a rise in their yields. A shift of money toward long-term assets will increase their prices and lower their yields. Thus, this shift in money raises short-term yields and lowers long-term yields, so a downward-sloping yield curve tends to emerge.
In the ET framework, given that the central bank determines short-term rates via the policy rate, it also follows that in this framework both short-term and long-term interest rates are determined by the central bank.
Does the Central Bank Determine Interest Rates?
Contrary to the ET framework, interest rates are not determined by the central bank’s monetary policy but by individuals’ time preferences. The phenomenon of interest is the outcome of the fact that individuals assign a greater importance to goods and services in the present versus identical goods and services in the future. The higher valuation is not the result of some capricious behavior, but because of the fact that life in the future is not possible without sustaining it first in the present.
If the means at an individual’s disposal are only sufficient to accommodate his immediate needs, he likely will assign a low importance to future goals. With the expansion of the pool of means, however, the individual can now allocate some of those means toward the accomplishments of various ends in the future. The individuals’ time preference will be lowered, resulting in the lowering of the interest rate.
Again, with the expansion in the pool of means, individuals can allocate more resources toward accomplishment of remote goals to improve their own quality of life over time. Interest rate are just indicators that reflect individuals’ decisions regarding present consumption versus future consumption. In a free, unhampered market, fluctuations in interest rates will be in line with changes in consumers’ time preferences. Thus, a decline in the interest rate is likely a, response to the lowering of individuals’ time preferences.
Consequently, when businesses observe a decline in the market interest rate they, likely respond by increasing their investments in tools and machinery in order to accommodate in the future the expected increase in consumer goods demand.
Shape of the Yield Curve in an Unhampered Market
According to Ludwig von Mises, the natural tendency of the shape of the yield curve in a free market is neither toward an upward sloping nor toward a downward sloping but rather toward being horizontal. (Observe that the horizontal yield curve emerges after adjusting for risk.)
Similarly, Murray Rothbard held that in a free market economy, an upward sloping curve could not be sustained for it would set in motion an arbitrage between short and long-term securities. Funds would be shifted from short maturities to long maturities. This would lift short-term interest rates and lower long-term interest rates, resulting in the tendency toward a uniform interest rate throughout the term structure.
Arbitrage helps prevent the sustainability of a downward sloping yield curve by shifting funds from long maturities to short maturities, thereby flattening the curve. Hence, in a free-market economy a prolonged upward or downward sloping yield curve is unsustainable.
The Fed’s Tampering Alters the Shape of the Yield Curve
The Fed’s monetary policies disrupt the natural tendency toward uniformity of interest rates along the term structure. This disruption leads to the deviation of market short-term rates from individuals’ time preference rates, which, in turn, leads to misallocation of resources and the boom-bust economic cycle.
As a rule, Fed policy makers decide their interest rate stance by observing the expected state of the economy and price inflation. Thus, whenever the economy shows signs of weakness and price indexes starts to ease, investors in the market form expectations that the Fed will soon lower its policy interest rate.
As a result, short-term interest rates move lower. The spread between long-term rates and short-term rates widens and the process of the development of an upward sloping yield curve is set in motion.
This process, however, cannot be maintained without the Fed actually lowering the policy rate. For the positive sloped yield curve to be sustained, the central bank must persist with its intervention. Should the central bank cease with its easy monetary policy the shape of the yield curve would tend to flatten.
Simultaneously, whenever economic activity shows signs of strengthening, coupled with an increase in price inflation, investors in the market start form expectations that in the near future the Fed will raise its policy rate. As a result, short-term interest rates move higher.
The spread between the long-term rates and the short-term rates begins to decline—the process of the development of a downward sloping yield curve is now set in motion. This process, however, cannot be maintained without the Fed actually increasing the policy rate.
We note that the Fed’s tampering with short-term interest rates distorts the natural tendency of the yield curve to gravitate toward the horizontal shape. Whenever the central bank reverses its monetary stance and alters the shape of the yield curve it sets in motion either an economic boom or an economic bust.
These booms and busts arise with lags—they are not immediate. This is because the effects of a change in monetary policy move gradually from one part of the economy to another, from one individual to another individual.
A change in the shape of the yield curve emerges in response to Fed policy makers setting targets to the federal funds rate. Both the upward and the downward sloping yield curves are the outcome of the central bank tampering with financial markets. This tampering results in the deviation of market interest rates from the time preference interest rates. Consequently, this results in the boom-bust cycles. In a free unhampered market after adjusting for risk, the shape of the yield curve will be horizontal.