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Forecasting Consumption Growth with the Real Term Structure

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Author Info
Kwok Ping Tsang

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Abstract

From the log-linearized consumption Euler equation, consumption growth of any horizon m is a function of the expected real return of maturity m, and they are linked through the elasticity of intertemporal substitution (EIS). Instead of using only the 1- period return and consumption growth, this result allows us to use the term structure of interest rates to identify the EIS. Using quarterly US data from 1954Q1 to 2007Q4, GMM results show that the real term structure is unrelated to future consumption growth: after controlling for small sample bias, we cannot reject the hypothesis that the EIS is zero. However, allowing a break in 1979 changes the results dramatically: the EIS is around 0.4 in the first period and it drops to around 0.2 in the second period. Not only is the EIS smaller, the out-sample forecasting power of ex post real return also drops in the second subsample compared to a simple AR(1) model for consumption growth. I find a lower EIS also for annual data.

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File URL: ftp://repec.econ.vt.edu/Papers/Tsang/consumption_growth.pdf
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Paper provided by Virginia Polytechnic Institute and State University, Department of Economics in its series Working Papers with number e07-14.

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Length: 26 pages
Date of creation: 2008
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Handle: RePEc:vpi:wpaper:e07-14

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Keywords: Consumption Euler Equation; Term Structure of Interest Rates; Inflation; Forecast; Elasticity of Intertemporal Substitution; GMM;

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  2. Blundell, Richard & Browning, Martin & Meghir, Costas, 1994. "Consumer Demand and the Life-Cycle Allocation of Household Expenditures," Review of Economic Studies, Blackwell Publishing, vol. 61(1), pages 57-80, January. [Downloadable!] (restricted)
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  3. Attanasio, Orazio P & Browning, Martin, 1995. "Consumption over the Life Cycle and over the Business Cycle," American Economic Review, American Economic Association, vol. 85(5), pages 1118-37, December. [Downloadable!] (restricted)
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  4. Robert E. Hall, 1988. "Intertemporal Substitution in Consumption," NBER Working Papers 0720, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  5. Masao Ogaki & Carmen M. Reinhart, 1998. "Measuring Intertemporal Substitution: The Role of Durable Goods," Journal of Political Economy, University of Chicago Press, vol. 106(5), pages 1078-1098, October. [Downloadable!] (restricted)
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  6. Nelson, Charles R & Kim, Myung J, 1993. " Predictable Stock Returns: The Role of Small Sample Bias," Journal of Finance, American Finance Association, vol. 48(2), pages 641-61, June. [Downloadable!] (restricted)
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  8. Mankiw, N. Gregory & Zeldes, Stephen P., 1991. "The consumption of stockholders and nonstockholders," Journal of Financial Economics, Elsevier, vol. 29(1), pages 97-112, March. [Downloadable!] (restricted)
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  9. Kreps, David M & Porteus, Evan L, 1978. "Temporal Resolution of Uncertainty and Dynamic Choice Theory," Econometrica, Econometric Society, vol. 46(1), pages 185-200, January. [Downloadable!] (restricted)
  10. Guvenen, Fatih, 2006. "Reconciling conflicting evidence on the elasticity of intertemporal substitution: A macroeconomic perspective," Journal of Monetary Economics, Elsevier, vol. 53(7), pages 1451-1472, October. [Downloadable!] (restricted)
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  11. Harvey, Campbell R., 1988. "The real term structure and consumption growth," Journal of Financial Economics, Elsevier, vol. 22(2), pages 305-333, December. [Downloadable!] (restricted)
  12. Diebold, Francis X. & Rudebusch, Glenn D. & Borag[caron]an Aruoba, S., 2006. "The macroeconomy and the yield curve: a dynamic latent factor approach," Journal of Econometrics, Elsevier, vol. 131(1-2), pages 309-338. [Downloadable!] (restricted)
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  13. Chapman, David A., 1997. "The cyclical properties of consumption growth and the real term structure," Journal of Monetary Economics, Elsevier, vol. 39(2), pages 145-172, July. [Downloadable!] (restricted)
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