This post will hopefully explain Paul Krugman's great interpretation of the yield curve... it's caused by the zero bound on the front-end of the curve. First to Paul...
As I tried to explain last time, to a first approximation you can think of the long term rate as reflecting an average of expected future short-term rates. Short-term rates, in turn, tend to reflect the state of the economy: if the economy improves, the Fed will raise short-term rates, if the economy worsens, the Fed will cut. So long-term rates can be either above or below short rates.
Except that now they can’t. If the economy improves, short rates will rise; but if it worsens, well, they’re already zero, so there’s nowhere to go but up. This implies that there has to be a positive term spread.
Where I really lose Krugman is when he seems to imply that the steep yield curve is the result of nominal short rates being near zero. I have no problem accepting that the curve should be positive but I don’t get how that ought to impact its unusual steepness. After all, the two-ten spread recently hit an all-time record.
Yield Curve Due to Zero Bound Rates
Running this hundreds of times (built a nice little spreadsheet I must say), the charts all looked roughly the same (just different scales).
I hope this was helpful...