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

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  • Carlo Favero
  • Iryna Kaminska
  • Ulf Soderstrom

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 IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University in its series Working Papers with number 280.

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Date of creation: 2005
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Handle: RePEc:igi:igierp:280

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  1. Stephen G. Cecchetti & Alfonso Flores-Lagunes & Stefan Krause, 2006. "Has Monetary Policy become more Efficient? a Cross-Country Analysis," Economic Journal, Royal Economic Society, Royal Economic Society, vol. 116(511), pages 408-433, 04.
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Cited by:
  1. Hogrefe, Jens, 2007. "The yield spread and GDP growth - Time Varying Leading Properties and the Role of Monetary Policy," Economics Working Papers, Christian-Albrechts-University of Kiel, Department of Economics 2007,12, Christian-Albrechts-University of Kiel, Department of Economics.
  2. Modena, Matteo, 2008. "The term structure and the expectations hypothesis: a threshold model," MPRA Paper 9611, University Library of Munich, Germany.
  3. 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, University of Pavia, Department of Economics and Quantitative Methods 105, University of Pavia, Department of Economics and Quantitative Methods.
  4. Modena, Matteo, 2008. "Yield curve, time varying term premia, and business cycle fluctuations," MPRA Paper 8873, University Library of Munich, Germany.
  5. Mario Reyna Cerecero & Diana Salazar Cavazos & Héctor Salgado Banda, 2008. "The Yield Curve and its Relation with Economic Activity: The Mexican Case," Working Papers, Banco de México 2008-15, Banco de México.
  6. Hans Dewachter & Leonardo Iania & Marco Lyrio, 2014. "Information in the yield curve: A Macro-Finance approach," Working Paper Research, National Bank of Belgium 254, National Bank of Belgium.
  7. Pesaran, M.H. & Schuermann, T. & Smit, L.V., 2008. "Forecasting Economic and Financial Variables with Global VARs," Cambridge Working Papers in Economics, Faculty of Economics, University of Cambridge 0807, Faculty of Economics, University of Cambridge.
  8. Peter N. Ireland, 2014. "Monetary Policy, Bond Risk Premia, and the Economy," Boston College Working Papers in Economics, Boston College Department of Economics 852, Boston College Department of Economics.
  9. Jardet, C. & Monfort, A. & Pegoraro, F., 2009. "No-arbitrage Near-Cointegrated VAR(p) Term Structure Models, Term Premia and GDP Growth," Working papers, Banque de France 234, Banque de France.
  10. 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, Federal Reserve Bank of St. Louis, issue Jul, pages 241-270.

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