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

  • Carlo Favero
  • Iryna Kaminska
  • Ulf Soderstrom

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. John Y. Campbell & John H. Cochrane, 1995. "By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," NBER Working Papers 4995, National Bureau of Economic Research, Inc.
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  9. Mardi Dungey & Vance L Martin & Adrian R Pagan, 2000. "A multivariate latent factor decomposition of international bond yield spreads," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 15(6), pages 697-715.
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  14. Hamilton, James D & Kim, Dong Heon, 2002. "A Reexamination of the Predictability of Economic Activity Using the Yield Spread," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 34(2), pages 340-60, May.
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  16. Michael Dotsey, 1998. "The predictive content of the interest rate term spread for future economic growth," Economic Quarterly, Federal Reserve Bank of Richmond, issue Sum, pages 31-51.
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