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.
KeywordsTerm Structure of Interest RatesMonetary PolicyBusiness CycleRecursive PreferencesStochastic Volatility
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