The Term Structure of Interest Rates, Real Activity and Inflation

This paper examines, both theoretically and empirically, the relationship between the slope of the yield curve and future changes in real activity and inflation. It argues that the existence of sticky prices allows current and expected future monetary shocks to affect the slope of both the <em>nominal</em> and the <em>real</em> yield curves. Changes in real money balances brought about by monetary policy cause a strong liquidity effect at the short end of the yield curve. This results in changes in real output in the short/medium term which eventually get translated into changes in prices. The empirical results show that the spread between the 10 year Treasury bond and the 180 day bank bill predict the rate of change, over the subsequent one to two years, of a number of measures of real activity. Over both longer and shorter forecast horizons the spread has little predictive power. On the inflation front, the 10 year-180 day yield spread provides significant information about changes in inflation over the medium term (that is between one year and two and three years). Yield spreads between shorter dated securities are found to contain little information concerning future changes in inflation. This supports the view that at the shorter end of the yield curve changes in nominal rates often reflect changes in real rates.