Q. What's a yield curve? A. Bonds with identical risk, liquidity and tax characteristics usually have different interest rates because of different times remaining to maturity. A yield curve is a picture contrasting yields with time to maturity for similar bonds. Yield curves usually slope upward because bonds with longer time to maturity usually pay higher interest rates.
Q. Why are higher yields associated with bonds that have a longer maturity? A. A longer-term bond involves more risk from interest rate fluctuations. Also, the longer-term bond encompasses expected inflation over the life of the bond. You may recall that nominal interest rates equal the real interest rate plus expected inflation. For example, if the real interest rate is 2.5% and expected inflation is 2%, the nominal interest rate would be 4.5%. Longer-term bonds require compensation for this inflation risk.
Q. Why do long-term interest rates sometimes rise when the Fed cuts the federal funds target, causing short-term interest rates to fall? A. Although the Fed can exert considerable influence over short-term rates, changes in inflation expectations can confound the effect of the federal funds target changes on longer-term rates. Easier monetary policy lowers short-term rates now, often at the expense of higher prices in the future.
Q. What causes the yield curve to be inverted? A. Although the yield curve is often upward sloping, sometimes it is downward sloping, in which case it is referred to as inverted. In this case, short-term interest rates are higher than long-term interest rates. If financial markets expect a weakening economy, long-term rates may fall relative to short-term rates. Although an inverted yield curve doesn't always signal a recession, it does indicate the markets' future expectations regarding the direction of the economy's performance.

The content for Q & A was adapted from "The Long and the Short of the Federal Funds Target Cuts," which was written by Michael T. Owyang, economist at the Federal Reserve Bank of St. Louis, and appeared in the September 2001 issue of Monetary Trends, a St. Louis Fed publication.