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The Yield Curve And Gdp – A Causal Relationship?

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http://bawerk.net/2015/10/30/the-yield-curve-and-gdp-a-causal-relationship/

One of the most reliable indicators of an imminent recession through recent history has been the yield curve. Whenever longer dated rates falls below shorter dated ones, a recession is not far off. Some would even say that yield curve inversion, or backwardation, help cause the economic contraction.

To understand how this can be we first need to understand what GDP really is. Contrary to popular belief, GDP only has an indirect relation to material prosperity. Broken down to its core component, GDP is simply a measure of money spent on goods and services during a specified period, usually a year or a quarter.

However, since money itself is a very fleeting concept we need to dig deeper to fully understand the relation between the slope of the yield curve and GDP. The core of money is its function as the generally accepted medium of exchange, but today that is much more than the cash in your wallet. For example, the base money, provided by the central bank, consist of currency in circulation and banks reserves held at the central bank.

From these central bank reserves the commercial banking system can leverage up, through fractional reserve lending practice, several times over. It is important to note that broader money supply measures, such as M2, is merely a reflection of banks leverage on top of base money. As a bank makes a loan to a borrower the bank creates fund which can be used as means of payments to whatever the borrower wants to spend the newly acquired money on. Obviously, these money claims will in turn create new deposits, which can be used to create new loanable funds and so on ad infinitum.

..

In the chart below we plot the difference between the actual Fed Fund rate and the Taylor rule. When the area between the two are red it means actual target rates are below the Taylor rule. While we are no big fan of the arbitrarily set Taylor rule, it has proven to provide a warning sign in times when the FOMC ignore it for longer periods. In the late 1970s and 2000s the result was obvious for all to see. Financial crisis, misallocations and subsequent capital reallocation (recession) were necessary. Today the FOMC is doing the exact same mistake again. The red area in the chart are growing ever larger as bond, stock, EM and who knows what are priced to perfection.Taylor-Rule-Deviation.png?resize=730%2C3

Source: Federal Reserve, Bureau of Economic Analysis, Bawerk.net

It is clear to us that the FOMC in its quest to maintain stability is breeding instability and that previous attempts at the same failed miserably with dire consequences for society. We are sure it is only a matter for time before it happens again.

Stability is the fools paradise.

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Stability is the fools paradise.

Not sure what point you are driving at but wikipedia says this:

"The rule was first proposed by John B. Taylor,[1] and simultaneously by Dale W. Henderson and Warwick McKibbin in 1993.[2] It is intended to foster price stability and full employment by systematically reducing uncertainty and increasing the credibility of future actions by the central bank."

Following the Taylor rule is supposed to provide stability.

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Not sure what point you are driving at but wikipedia says this:

"The rule was first proposed by John B. Taylor,[1] and simultaneously by Dale W. Henderson and Warwick McKibbin in 1993.[2] It is intended to foster price stability and full employment by systematically reducing uncertainty and increasing the credibility of future actions by the central bank."

Following the Taylor rule is supposed to provide stability.

Another scientifically illiterate Keynesian believer in rational expectations and sticky prices. :rolleyes:

He deserves a rainbow narwhal for his professional accomplishments not the Nobel Prize.

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