Many people look at the spread between the yield on 2-year and 10-year Treasury securities as a forecasting tool for the business cycle. It is indeed a much better than average economic indicator, often “inverting” about a year before a recession. But there are also several misconceptions about the yield spread, which I’d like to discuss here:

1. You cannot reliably manipulate the economy by manipulating the yield spread.  This is an example of the “Lucas Critique”.  The yield spread predicts output because movements in short-term interest rates are strongly correlated with the business cycle.  But changes in the yield spread do not cause changes in the business cycle. If the yield spread had a causal impact, then announcements of QE programs aimed at flattening the yield curve would have had a contractionary impact on asset prices.  But they didn’t.

2. The implications of a sharp decline in the yield spread are far different from the implications of an outright inversion of the yield spread.  This is important, as the following graph demonstrates that the yield spread has recently declined sharply, but remains positive:

There were similar sharp declines in the yield spread in 1977, 1984, and 1994, and yet in each case there was no recession in the near future.

3.  The yield spread is not a particularly good indicator of whether money is too tight.  Consider the following two yield spreads:

February 2006:  minus 0.14%

December 2007:  positive 0.99%

The February 2006 inversion did not indicate that money was too tight at that point in time.  In contrast, money was clearly too tight in December 2007, and yet the yield spread was about normal, which is roughly 1%.

The yield spread also inverted in June 1998, and yet money was not too tight at that time.  Nor was money too tight in January 1989, when the yield curve inverted.  And obviously money was not too tight in the late 1970s.  Don’t make the mistake of equating “yield curve is inverted” with “money is currently too tight”.

The best measure of whether money is too tight is the Hypermind NGDP prediction market price.  And that’s a really, really sad comment on the failure of our policymakers, as well as the economics profession as a whole.

PS.  David Beckworth has a somewhat different perspective on the yield spread.