Wednesday, June 10, 2009

Whats going on with the yield curve part 2: Does a steepening of slope imply growth?

I'm having a hard time with this one. The model I use for forecasting real GDP growth relies on changes in the slope of the yield curve as the mechanism by which monetary policy works. As discussed previously, the slope of the Government yield curve (10yr - 3month) has steepened dramatically in the past month. This steepening is often interpreted as a positive signal that market participants expect short-term rates to rise in the future as growth and eventually inflation pick-up. What I am having a difficult time with is whether this is the right way to interpret what is currently happening in the Canadian economy. The Bank of Canada is certainly not going to be raising rates any time soon, and research by the IMF shows that recoveries from recessions caused by financial crises tend to be slow.

The forecast implications are significant. Ignoring the signal from the yield curve implies a less robust recovery while accepting it provides a recovery akin to what the Bank of Canada forecast in its last MPR. The figure below illustrates the incremental growth implied by the yield curve shock (versus a control baseline of ignoring the signal, eg, running a simulation in which no steepening occurred

I'm leaning towards interpreting the movement in the yield curve as simply the normalization of inflation expectations and the impact of the "flight from quality" as investors regain confidence. Anyone want to try to convince me otherwise?


Stephen Gordon said...

The Bank of Canada is certainly not going to be raising rates any time soon

That actually does show up in the yield curves; they are still flat a year out, and only start jumping up at the 2-year horizon. That looks to me as though people are expecting a recovery and that the Bank will increase interest rates soon after its self-imposed moratorium has expired.

As for the point of financial crises: we really didn't have one. Those stories are about how long it takes for banks to rebuild their balance sheets, and we don't have that problem.

Shock Minus Control said...

That is a very good point Stephen, though I wonder about the impact on Canadian corporate borrowing in the US, which certainly did/does have a financial crisis.

Stephen Gordon said...

That's the thing I don't know, either.