The Predictive Power of the Yield Spread: Further Evidence and a Structural Interpretation
36 Pages Posted: 14 Jun 2005
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The Predictive Power of the Yield Spread: Further Evidence and a Structural Interpretation
Date Written: February 2005
Abstract
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.
Keywords: Yield curve, term structure of interest rates, predictability, forecasting, GDP growth, estimated Euler equation
JEL Classification: E27, E37, E43
Suggested Citation: Suggested Citation
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