Forecasting Output Growth using a DSGE-Based Decomposition of the South African Yield Curve

Evidence in favor of the ability of the term spread to forecast economic growth of the South African economy is non-existent. Presuming that this could be due to the term spread aggregating, and hence loosing out on important, information contained in the expected spread and the term premium, we: (i) Develop an estimable Small Open Economy New Keynesian Dynamic Stochastic General Equilibrium (SOENKDSGE) model of the in ation targeting South African economy; (ii) Use the SOENKDSGE model, estimated using Bayesian methods, to decompose the term spread into an expected spread and the term premium over the quarterly period of 2000:01-2014:04, and; (iii) Use a linear predictive regression framework to analyze the out-of-sample forecasting ability of the aggregate term spread, as well as the expected spread and term premium. Our forecasting results fail to detect forecasting gains from the aggregate term spread and also the term premium, but the expected spread is found to contain important information in forecasting the output growth over short- to medium-run horizons, over the out-of-sample period of 2004:01-2014:04. In other words, we confirm our presumption, and in the process highlight the importance of the forward looking component of the term spread, i.e., the expected spread, in forecasting output growth of South Africa.