This paper offers a structural interpretation of the “leading indicator” properties of the yield curve observed in
conventional times of monetary policy. Low levels of nominal interest rates and
inflation, but a steeper yield curve, typically precede economic expansions.
According to the model, if investors use bond markets mainly to hedge risk,
positive economic news are only weakly transmitted into real interest rates,
but monetary policy transmits them into lower inflation and nominal rates. A
steeper yield curve reflects both expected faster growth and higher uncertainty
about the growth path. Importantly, the mechanism conforms with other important
term structure properties.
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