A Note on the (continued) Ability of the Yield Curve to Forecast Economic Downturns in South Africa

In 2002/03 the yield spread falsely signalled a downswing that never materialised. This paper provides two reasons for this false signal. Firstly, while the Reserve Bank never actually officially declared the start of a downswing, by other important measures a downswing did actually occur. It is to this slowing in economic activity at that time that the yield curve pointed. Secondly, short-term interest rates in 2003 were higher than they should have been because of a mistake made in measuring consumer price inflation. Because South Africa had recently introduced an inflation targeting regime, policy interest rates were as a result of this error kept too high for too long. This policy mistake was rectified as soon as the error in the Consumer Price Index was discovered. Thus, the yield curve in 2002/03 pointed to the reality that short-term interest rates were too high and risked pushing the economy into recession. This is demonstrated by the fact that it was a fall in long bond interest rates that cause the yield spread to turn negative, indicating expectations that short-term interest rates would need to be cut – as indeed they were.