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The Predictive Power of the Yield Spread: Further Evidence and A Structural Interpretation

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  • Favero, Carlo A
  • Kaminska, Iryna
  • Söderström, Ulf

Abstract

This paper brings together two strands of the empirical macro literature: the reduced-form evidence that the yield spread helps in forecasting output and the structural evidence on the difficulties of estimating the effect of monetary policy on output in an intertemporal Euler equation. We show that including a short-term interest rate and inflation in the forecasting equation improves the forecasting performance of the spread for future output but the coefficients on the short rate and inflation are difficult to interpret using a standard macroeconomic framework. A decomposition of the yield spread into an expectations-related component and a term premium allows a better understanding of the forecasting model. In fact, the best forecasting model for output is obtained by considering the term premium, the short-term interest rate and inflation as predictors. We provide a possible structural interpretation of these results by allowing for time-varying risk aversion, linearly related to our estimate of the term premium, in an intertemporal Euler equation for output.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 4910.

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Date of creation: Feb 2005
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Handle: RePEc:cpr:ceprdp:4910

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Keywords: estimated Euler equation; forecasting; GDP growth; predictability; term structure of interest rates; yield curve;

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References

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Cited by:
  1. M. Hashem Pesaran & Til Schuermann & L. Vanessa Smith, 2008. "Forecasting economic and financial variables with global VARs," Staff Reports 317, Federal Reserve Bank of New York.
  2. Hogrefe, Jens, 2007. "The yield spread and GDP growth - Time Varying Leading Properties and the Role of Monetary Policy," Economics Working Papers 2007,12, Christian-Albrechts-University of Kiel, Department of Economics.
  3. Matteo Modena, 2008. "The Term Structure and the Expectations Hypothesis: a Threshold Model," Working Papers 2008_36, Business School - Economics, University of Glasgow.
  4. Jardet, C. & Monfort, A. & Pegoraro, F., 2009. "No-arbitrage Near-Cointegrated VAR(p) Term Structure Models, Term Premia and GDP Growth," Working papers 234, Banque de France.
  5. Modena, Matteo, 2008. "Yield curve, time varying term premia, and business cycle fluctuations," MPRA Paper 8873, University Library of Munich, Germany.
  6. Carluccio Bianchi & Alessandro Carta & Dean Fantazzini & Maria Elena De Giuli & Mario A. Maggi, 2009. "A Copula-VAR-X Approach for Industrial Production Modelling and Forecasting," Quaderni di Dipartimento 105, University of Pavia, Department of Economics and Quantitative Methods.
  7. Glenn D. Rudebusch & Brian P. Sack & Eric T. Swanson, 2007. "Macroeconomic implications of changes in the term premium," Review, Federal Reserve Bank of St. Louis, issue Jul, pages 241-270.
  8. Dewachter, Hans & Iania, Leonardo & Lyrio, Marco, 2011. "Information in the Yield Curve: A Macro-Finance Approach," Ibmec Working Papers wpe_230, Insper Working Paper, Insper Instituto de Ensino e Pesquisa.
  9. Mario Reyna Cerecero & Diana Salazar Cavazos & Héctor Salgado Banda, 2008. "The Yield Curve and its Relation with Economic Activity: The Mexican Case," Working Papers 2008-15, Banco de México.

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