How are predictions related to monetary policy?
A. Although there are different views of the instruments and channels of monetary policy, a tightening of monetary policy usually means a rise in short-term interest rates, typically intended in the end to lead to a reduction in inflationary pressures. When those pressures subside, it is expected that a policy easing will follow. Expected future short-term rates are important determinants of current long-term rates. Thus, long rates tend to respond to a monetary tightening by increasing, though given that a policy reversal is expected, they tend not to increase by as much as short-term rates. Thus, a simple explanation of the predictive power of the yield curve for future output growth is that a monetary tightening both slows down the economy and flattens (or even inverts) the yield curve. Monetary policy is therefore an important determinant of the predictive power of the yield curve. However, given that private-sector expectations are incorporated in interest rates, and given that th
