An Empirical Study on Stabilities of the Predictive Role of the Yield Spread for Future Economic Activity and the Monetary Policy Stance in Japan

This paper examines the relationship between the stability of the monetary policy reaction function and that of the predictive power of the yield spread for future economic activity using Japanese quarterly data between 1982:3 and 2005:2. We find that four structural changes occurred in the reaction function at 1985:4, 1991:2, 1994:4 and 2000:4 on the basis of Bai and Perron tests for unknown multiple breaks. The estimation results of the reaction function in the five subsamples show that, whereas the monetary policy reacts positively to the output gap before the mid-1990s, subsequently the reaction tends to decline and becomes almost nonexistent in the 2000s. The investigation of the predictive power of the yield spread for future GDP growth shows that before the mid-1990s, the spread contains information on future GDP growth, but that the spread loses its prediction power in the 2000s. This evidence shows that the stable monetary policy reaction to the output gap may cause the predictability of the yield spread for future GDP growth.