Long term rates and the yield curve

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    In the past, the yield curve is used as a great predictor of when the boom is over and a bust is coming. When the Fed raises interest rates (and decreases credit expansion), short-term rates go up, and the difference between short-term and long-term rates decrease. What happens when long-term rates increase, making the yield curve steeper? I am assuming long-term rates are rising due to price inflation expectations, but does this mean that the Fed has to raise interest rates more in order for the yield curve to invert and a recession to occur?


    An inverted yield curve, i.e., when short rates are above long rates, is associated with downturns.

    Here is a short piece by Bob Murphy showing that inversions occur because short rates spike upward relative to long rates.


    Here is a paper by Murphy explaining the yield curve, see section IV.


    Because of arbitrage across the yield curve, normal movements in long rates tend to be matched by movements in short rates. Since the Fed manipulates the short end of the yield curve, the abnormal steepening and flattening typically occur from short rate movements not long. Take a look at figure 2 on p. 33 of Murphy’s paper.


    Thanks for linking the paper, but it has caused more questions than answers.

    1. “Yet virtually everyone would agree that the banks have much more control over short-term than long-term rates, so “the” interest rate in the standard
    exposition of ABCT should be interpreted as short rates.” (31-32)

    A. Why must this be so? Why does the Fed’s credit expansion only push down short-term rates? Why aren’t long-term rates affected by this (why isn’t there downward pressure on long-term rates)?

    B. Does QE affect long-term rates?

    C. If conventional monetary policy (Fed Funds Rate) does not put much or any downward pressure on long-term rates, how does a bubble form? Aren’t mortgages and commercial loans typically long-term loans?

    2. “A third—and far more speculative—observation is that Austrians may be able to explain periods such as the early 1980s and again the early 1990s when short-term rates (the blue line) spiked, and yet no recession ensued. What is interesting in these two periods is that long rates spiked just as much, keeping the term spread intact. It is possible that these shifts upward of the entire yield curve were due to more fundamental changes in savings behavior, rather than bank policy. In that case, it makes sense that the spike in short-term rates did not lead to a recession, as it so often does at other times in the period surveyed.” (33)

    A. Why do higher long-term rates not cause a recession?

    B. If long-term and short-term rates are going up (causing the spread to stay the same), how come that does not cause a recession as well? It makes sense that credit expansion is still going on, but if rates go up, doesn’t that make a lot of these projects unprofitable?

    I know this is a lot to answer, but I appreciate the responses! Let me know if I need to clarify my questions.


    The claim is that Fed policy of providing bank reserves through open market operations and other asset purchases, must decrease the fed funds rate since that is the rate for trading bank reserves. How the ensuing credit expansion affects other interest rates depends on bank lending, not on Fed policy. And the interest return on longer projects in production also depend on entrepreneurial decisions to invest.

    Without monetary inflation and credit expansion, banks are constrained to intermediate credit across the yield curve according to underlying factors, e.g., the intensity of savers’ time preferences for shorter v. longer lending, differences in uncertainty, etc. The resulting yield curve, then, would reflect these underlying factors.

    1. With monetary inflation providing more bank reserves, banks have no constraint from savers’ time preference in creating credit across the time structure. They are not intermediating savers’ lending, but creating loans. With Fed bailout guarantees, banks tend to leverage credit creation flattening the yield curve.

    When longer-term credit interest rates decline, then arbitrage opportunities exist for shifting capital funding into longer production processes until the rate of return on those projects conforms to the lower long-term interest rates.

    Since the Fed cannot control but only influence these broader interest rates and rates of return, it tends to excesses in monetary policy as its initial monetary stimulus may have little effect. In this way, the Fed is the source of volatility of the yield curve slope.

    2. The reason changes in underlying time preferences do not cause booms and busts is because the ensuing building up and tearing down of the capital structure is sustainable. The built-up capital structure caused by lower time preference is sustained by the greater saving-investing. The torn-down capital structure caused by higher time preference is sustained by the smaller saving-investing.

    The boom is set in motion by credit expansion without any additional saving-investing from people and therefore, results in a built-up capital structure that cannot be sustained and must be torn down to match people’s underlying time preference.

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