Why Does the Yield Curve Predict Output and Inflation ?

The slope of the yield curve has been shown empirically to be a significant predictor of inflation and real economic activity, but there is no standard theory as to why the relationship exists. This paper constructs an analytical rational expectations model to investigate the reasons for the empirical results. The model suggests that the relationships are not structural but are instead influenced by the monetary policy regime. However, the yield curve should have predictive power for output and inflation in most circumstances. Various implications of the theoretical model are tested and confirmed empirically. The views expressed in this paper are those of the author and do not necessarily represent those of the Federal Reserve Bank of New York or the Federal Reserve System. Abstract The slope of the yield curve has been shown empirically to be a significant predictor of inflation and real economic activity, but there is no standard theory as to why the relationship exists. This paper constructs an analytical rational expectations model to investigate the reasons for the empirical results. The model suggests that the relationships are not structural but are instead influenced by the monetary policy regime. However, the yield curve should have predictive power for output and inflation in most circumstances. Various implications of the theoretical model are tested and confirmed empirically.