Monetary Policy and the Term Spread in a Macro Model of a Small Open Economy

Using a simple single-equation approach, many studies have shown that the term structure of interest rates or its approximation - the term spread - is a useful indicator of future inflation and/or future real economic activity. However, this paper argues that shortcomings of the single-equation approach may produce results that are biased, and that the predictive ability must be analyzed from within a model framework. We have elected to use a simple macroeconomic model of a small open economy and examine the predictive properties of the term spread from within its framework. The main contribution of this paper to the literature is threefold. First, we show that the predictive ability of the term spread is not structural but monetary-policy dependent. Second, we argue that the term spread's predictive ability with regard to future inflation (real economic activity) increases as more emphasis is placed on inflation (real economic activity) stabilization in the central bank's reaction function. Third, we show that understanding the way expectations are formed is an important prerequisite for using the term spread as an indicator. Apart from these general findings, the predictive power of the term spread is examined in the context of the Czech economy. It is shown that the term spread between one-year and three-month PRIBOR interest rates of one percentage-point indicates that agents expect inflation to be almost one percentage-point above the inflation target six quarters in the future.