Thinking about the yield curve in Euroarea..

An oldish speech by Vítor Constâncio of ECB, which I missed linking.

Euroarea is both frustrating and interesting in most matters. It does not change when we think about the yield curve.

First, what is it about the yield curve?

As we all know, the understanding of the dynamic evolution and the forecasting of the yield curve has many practical applications: pricing asset and derivatives, devising strategies for public debt programs, managing risk and conducting monetary policy. An old simple use of the yield curve, more common in the US, was to use its slope to forecast recessions. In 2009, Rudebusch and Williams 1 published a paper about what they call “the puzzle of the enduring power of the yield curve” to forecast recessions. In 2006, when the US yield curve got inverted predicting a recession, the whole idea was dismissed as having finally failed only to be confirmed by the Great Recession. In a very recent paper, Chinn and Kucko 2examine the issue for the US, the euro area and eight European countries. The results show that the slope indicator performance has deteriorated in recent years although it seems to work better than other leading indicators for some European countries.

Today we are mainly interested in examining the important role the yield curve has for the conduct of monetary policy.

The yield curve is important mainly for two reasons. First, it is an indicator of what the market is thinking about the expected path of future monetary policy. This follows because long-term rates under certain conditions reflect expectations of the future path of short-term rates. Of course, besides future rate expectations, longer maturity yields typically contain risk premia. The quantification of these premia is not without challenges even in normal times.

The second reason results from the yield curve being a key part of the transmission mechanism of monetary policy. Therefore, it is something the central bank wants to influence, not only just learn from. In particular, while the first step in the transmission process of monetary policy is typically related to very short-term interbank interest rates, the wider transmission requires that these effects spread more widely to medium- and longer-term rates. In the next step, the monetary policy impulse spreads to the pricing of assets that are relevant for the financing conditions of households and corporations, their consumption, production and investment decisions and, finally, inflation.

But in Euroarea which is the yield curve?

Naturally, the crisis has brought up a number of challenges for our understanding of the yield curve.

For example, credit and liquidity premia have been important drivers of sovereign yields in the euro area and elsewhere, thereby complicating the process of inferring market expectations of the future path of policy, and also impairing the transmission mechanism of monetary policy to the wider economy. Moreover, high sovereign spreads in the euro area have raised the question of what is the appropriate yield curve to monitor. In an article in the July Monthly Bulletin we discussed this issue in the context of measuring the euro area risk-free rate. Should we use Bund yields, euro area average AAA rates or OIS rates, or does it depend on the matter at hand?

Incidentally, an intriguing question in a currency union is the following: if it is difficult to identify a risk-free rate in a currency union, this means that there is no risk-free asset either, besides the central bank’s own liabilities, the currency. Whether this peculiar situation adds to the challenges facing the central bank of a monetary union, in terms of signal-extraction and analysis of expectations, I leave to you as a topic for reflection.

He further discusses how both macro models and fin models were not talking to each other. As a result, we missed the main stories.

Nice stuff..


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