- CFA Exams
- 2025 Level II
- Topic 9. Portfolio Management
- Learning Module 37. Economics and Investment Markets
- Subject 3. The Yield Curve and the Business Cycle

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##### Subject 3. The Yield Curve and the Business Cycle PDF Download

**Short-Term Interest Rate and the Business Cycle**

Short-term nominal interest rates are

*positively*related to short-term real interest rates and inflation expectations.

As discussed in the last section, short-term nominal interest rates are

*positively*related to the level and volatility of GDP growth.

The inflation environment is a key driver of short-term interest rates.

A responsible central bank usually bases its policy rate on the level of expected economic activity and inflation.

- If the nominal interest rates are considered too high, the central bank will cut its policy rate.
- If the nominal interest rates are considered too low, the central bank will raise its policy rate.

The

**Taylor rule**suggests setting a central bank's policy rate as follows:

where:

pr

_{t}= policy rate at time t

l

_{t}= real short term interest rate

i

_{t}= rate of inflation

i

^{*}

_{t}= target rate of inflation

Y

_{t}= the logarithmic level of actual GDP

Y

^{*}

_{t}= the logarithmic level of potential GDP

Y

_{t}- Y

^{*}

_{t}is known as

**output gap**. If it is positive, the economy is producing beyond its capacity and inflation is likely on the rise. If it is negative, unemployment may become an issue.

When inflation is close to the targeted rate and there is no output gap, the policy rate will be l

_{t}+ i

_{t}. This rate is referred to as the

**neutral policy rate**. The neutral policy rate is not constant, however. It can vary with the level of real economic growth and with the expected volatility of that growth.

Other factors being equal:

- When inflation is above (below) the targeted level, the policy rate should be above (below) the neutral rate.
- When the output is positive (negative), the policy rate should be above (below) the neutral rate.

The policy rate can thus vary over time with inflation expectations and the economy's output gap.

**Conventional Government Bonds**

This equation can be used to calculate the present value of any risk-free security.

θ

_{t,s}is the expected inflation and π

_{t,s}is the risk premium for the uncertainty of the expected inflation. π

_{t,s}can be negligible for short-term government securities but it can become significant for long-term government bonds.

The

**break-even inflation (BEI) rate**is defined as the difference between the yield on a zero-coupon default-free

*nominal*bond and the yield on a zero-coupon default-free

*real*bond of the same maturity. It incorporates both θ

_{t,s}and π

_{t,s}.

**The Default-Free Yield Curve and the Business Cycle**

The yield curve

*levels*are positively related to the level of economic activity and views of future inflation.

The

*slope*of the yield curve is influenced by the magnitude of the risk premium. The risk premium will generally rise with the maturity of these bonds because longer-dated government bonds tend to be less negatively correlated with consumption and therefore represent a less useful consumption hedge for investors.

Other factors can also affect the slope of the yield curve. For example, during a recession a central bank will tend to lower its short-term rates so the slope will increase. Inflation expectations, business cycle, and policymaker decisions can all influence the shape of the yield curve.

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**User Contributed Comments**
1

User |
Comment |
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davidt87 |
this curriculum is all over the place. i definitely shouldve done this section before the currency section |

I passed! I did not get a chance to tell you before the exam - but your site was excellent. I will definitely take it next year for Level II.