The flattening of the yield curve : causes and economic policy implications

The article examines the flattening of the yield curve in the euro area since mid 2004, and that in the United States where a slight inversion has actually been apparent since mid 2006. Analysis has shown that, apart from the tightening of monetary policy, this phenomenon is due to a substantial reduction in the risk premium, and especially its real component. It also indicates that this contraction was caused mainly by strong demand for government bonds on the part of atypical investors, in particular, the Asian central banks and pension funds. In addition, the study revealed that the reliability of break-even inflation as an indicator of inflation expectations is not really affected by this flattening, since the reduction in the inflation risk premium made only a small contribution to the contraction of the overall risk premium. Conversely, the analysis indicates that the quality of the yield curve as an advanced indicator of the business cycle is affected by the contraction of the risk premium. Since the flattening of the yield curve is due to adjustment of the risk premium rather than revised interest rate expectations, the current behaviour of the yield curve does not signal a marked slowdown in economic activity. Since, the contraction of the risk premium corresponds to an easing of financial conditions, the monetary authorities need to exercise great vigilance in order to ensure price stability in the medium term. Vigilance is all the more necessary if the reduction in the risk premium is not due to changes in the macroeconomic fundamentals. In that case, there is also the risk of a possible upward adjustment to long-term interest rates. However, it should also be noted that the demand currently exhibited by atypical investors seems to be more structural than that generated by the “flight to quality” which lay at the root of the decline in the risk premium during the period 1997-1998. The risk premium reduction which occurred between June 2004 and June 2005 therefore appears to be more persistent than that seen between mid 1997 and the end of 1998.