DP4910 The Predictive Power of the Yield Spread: Further Evidence and A Structural Interpretation

Author(s): Carlo A. Favero, Iryna Kaminska, Ulf Söderström
Publication Date: February 2005
Keyword(s): estimated Euler equation, forecasting, GDP growth, predictability, term structure of interest rates, yield curve
JEL(s): E27, E37, E43
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=4910

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.