What the Steep Yield Curve Means

Paul Krugman has a confusing post on the steep yield curve, at least it’s confusing to me. My rule is if I can’t follow what a Nobel laureate’s saying, then it’s a pretty good bet that it’s my fault.
Still, as I read Krugman he says that when he earlier discussed the yield curve, people thought it was “proof that the economy would recover soon,” but now people think it’s over “fears of default.” Yet Krugman writes that the reason for the steep curve “has nothing to do with either explanation.” But he essentially says that it’s the first reason—hopes for a recovery.
That’s only mildly confusing but where I really lose Krugman is when he seems to imply that the steep yield curve is the result of nominal short rates being near zero. I have no problem accepting that the curve should be positive but I don’t get how that ought to impact its unusual steepness. After all, the two-ten spread recently hit an all-time record.
I agree with Krugman’s view that we’ve become too inflation-phobic. When you have 15 million people out of work, it’s best to err on the side of higher inflation. I also agree that long-term inflation expectations are nothing to worry about. The ten-year TIPs spread is still mild. But I do believe the very steep yield curve is a result of higher inflation expectations. The hitch is that those expectations don’t say that inflation will go from a normal level to a danger level; they say that inflation will go from a dangerously low level to a normal level. The steep curve doesn’t merely reflect the future—half the variables are the present and the present ain’t normal.
The other issue I wanted to mention is that we shouldn’t focus on the 10-year TIPs spread. We should look at the TIPs curve leading up to ten years. It’s the expected forward inflation rate that I like to follow. Yet even when we do, I’m still in Krugman’s camp—inflation isn’t an important concern right now. (BTW, Krugman was very worried about inflation seven years ago.)

Posted by on April 1st, 2010 at 7:38 am


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