Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / Why Central Banks Are Watching the Yield Curve Slope
Transcript
- Lucas: Luna, I want to talk about something that's been getting a lot of attention in central banking circles lately, and it's not the level of interest rates. It's the slope of the yield curve. Luna: The slope — you mean the difference between short-term and long-term yields, right? Not the absolute level. Lucas: Exactly. For decades, central bankers mostly focused on the short end — they set the policy rate, and that determined short-term yields. The long end was left to the market. But more and more, they're realising that the slope itself tells you something about financial conditions that the policy rate alone doesn't capture. Luna: And this is separate from the yield curve inversion we talked about in a few earlier episodes. This is about the steepness or flatness, not just whether it's inverted. Lucas: Right. Inversion is an extreme version of flattening. But a flattening curve — even one that stays positive — can still signal that markets expect slower growth or tighter policy ahead. And that feeds back into the real economy through bank lending, mortgage rates, corporate borrowing costs. Luna: So the slope becomes a kind of automatic stabiliser, or maybe a destabiliser, depending on how it moves. Lucas: Precisely. And there's a fascinating paper from the Bank for International Settlements — published last year, 2025 — that proposed something they call the 'slope rule' for monetary policy. The idea is that central banks should adjust their policy rate partly based on the slope of the yield curve, not just on inflation and output. Luna: That's a pretty big departure from the Taylor Rule framework. How would it work in practice? Lucas: The authors argue that when the yield curve flattens — meaning long-term yields fall relative to short-term — it's a sign that financial conditions are tightening on their own. So the central bank can afford to keep rates lower, or even cut, because the curve is doing some of the work for them. Conversely, if the curve steepens, with long-term yields rising, that suggests easy financial conditions, and the central bank might need to hike more. Luna: So instead of just looking at the policy rate, you look at the whole term structure. That's elegant in theory, but is any central bank actually using it? Lucas: Not explicitly — no central bank has adopted it as a formal rule. But if you look at the European Central Bank's actions over the past year, there are signs they've been implicitly following something like it. Let me give you a concrete example. Luna: I'm all ears. Lucas: Back in January 2025, the spread between the 2-year and 10-year German Bund was around 150 basis points — that's a fairly steep curve. The ECB was in a tightening cycle, pushing rates up to combat lingering inflation. But by June of this year, 2026, that spread has narrowed to just 45 basis points. Luna: So a massive flattening — more than 100 basis points in eighteen months. Lucas: Exactly. And what did the ECB do? They paused rate hikes in early 2026, and some council members have started hinting at cuts later this year. Now, you could argue that's because inflation came down, but inflation was still above target when they paused. The flattening curve was a strong additional signal that conditions were tight enough. Luna: So the curve was doing the tightening for them. That's exactly the slope rule logic. Lucas: Right. And it's not just Europe. The Bank of Japan has been watching the slope of their yield curve like a hawk since they abandoned yield curve control. The Federal Reserve, too — several Fed presidents have mentioned the slope in speeches. They're all aware that a flattening curve can act as a headwind. Luna: But there's a counterargument, right? Some economists say the slope is just a market signal, not a policy tool. That it's noisy and can be distorted by things like quantitative easing or global safe-asset demand. Lucas: That's a fair critique. The slope is influenced by many factors — term premiums, global savings flows, central bank asset purchases. During the QE era, central banks intentionally compressed term premiums, which artificially flattened the curve. Using that distorted signal as a policy guide could lead you astray. Luna: So the slope rule might work better in normal times, when the central bank isn't actively buying long-term bonds. Lucas: Right. The BIS paper acknowledges that — they control for central bank balance sheet effects in their model. But even so, the slope seems to have predictive power for future output and inflation beyond what the policy rate alone provides. That's the key empirical finding. Luna: Let me push back a little. In the US, the yield curve inverted for nearly two years starting in 2023, and a recession never came. So isn't the slope a flawed signal? Lucas: That's the big counterexample. The inverted curve from mid-2023 to early 2025 was the longest inversion since the 1980s, and the recession that everyone predicted didn't materialise. But remember — inversion is a different beast. It's not just flattening; it's negative. And many economists argued that the inversion was distorted by the post-pandemic liquidity glut and the Fed's quantitative tightening. Luna: So the false positive from the inverted curve might actually argue against relying on the slope too heavily. Lucas: It does. But the slope rule isn't about binary recession calls. It's about the continuous calibration of policy. The BIS paper found that incorporating the slope improves the Taylor Rule's performance in terms of stabilising output and inflation, even if it doesn't perfectly predict turning points. Luna: Speaking of which — I want to ask about another angle. If central banks start targeting the slope, doesn't that create a moral hazard? Markets might think the central bank will always steepen the curve if it flattens too much, so investors take on more duration risk. Lucas: That's a real concern. It's the same kind of moral hazard that comes with any central bank reaction function. If the market knows the Fed will cut rates when the curve flattens, they might bid up long-term bonds without worrying about the consequences. The BIS paper doesn't address that directly, but it's a valid point. Luna: So where does this leave us? Is the slope rule likely to become a mainstream tool, or is it just an academic curiosity? Lucas: I think it's somewhere in between. It's not going to replace the Taylor Rule or inflation targeting any time soon. But central banks are already looking at the slope — they just don't formalise it. What the BIS paper does is give them a framework to think about it systematically. And in a world where neutral rates are uncertain and the transmission mechanism is changing, any additional information is valuable. Luna: Yeah, that makes sense. And honestly, if walking through the economy with us has made something click — if today's episode was worth a coffee to you — there's a simple way to support the show. It's buy me a coffee dot com slash fexingo. Just a small gesture, but it keeps this podcast ad-free and independent. Lucas: Absolutely. No pressure, but if you find value in these deeper dives, that link is there. And we really appreciate it. Now, back to the slope — one more angle I want to bring up. Luna: Let's hear it. Lucas: There's also a macroprudential dimension. A steep yield curve typically boosts bank profitability — banks borrow short and lend long, so a steep curve widens their net interest margin. That encourages lending. A flat or inverted curve squeezes margins, which can lead to a credit crunch. Luna: So the slope rule isn't just about inflation and output; it's also about financial stability. Lucas: Exactly. The BIS paper touches on this. They show that a flattening curve predicts tighter bank lending standards, even controlling for the policy rate. So if the central bank ignores the slope, they might inadvertently let financial conditions tighten too much, causing a credit crunch that hurts the economy more than necessary. Luna: That's a strong argument for at least monitoring the slope closely, even if you don't formalise a rule. Lucas: Right. And I think that's where most central banks are today. They watch the slope, they mention it in minutes, but they haven't codified it. The question is whether, in the next downturn, they might use the slope more actively — for instance, by communicating that they'll respond to steepening or flattening in a systematic way. Luna: That would be a big step. It would give markets a clearer sense of the reaction function. Lucas: It would. But for now, the slope remains a powerful but informal input. And as the spread between 2-year and 10-year Bunds continues to hover around 45 basis points, every ECB watcher is asking: will they cut rates to steepen the curve, or let it flatten further? The answer will tell us a lot about how seriously they take the slope. Luna: Alright, that's a great place to leave it. Lucas, thanks for unpacking that. Lucas: Thanks, Luna. And thanks to everyone listening. See you next time.