Why Does the Yield Curve Predict Economic Activity?

There is a significant amount of empirical evidence to suggest that the yield curve is useful for forecasting inflation, recessions, and possibly even the growth rate of real output. This essay considers the theoretical reasons why the yield curve may have these predictive properties. It is found that the essential reason why the yield curve predicts inflation and recessions is that it, through the expectations hypothesis, embodies market expectations of future nominal interest rates. From this, the market expectations of future inflation can be directly determined. Additionally, a recession can be predicted by the yield curve if the market predicts it and expected future interest rates change consequently. In the case of forecasting real output, expectations of monetary policy reactions to demand and supply shocks are found to play the central role.