Does the Yield Spread Predict Real Economic Activity?

Abstract

Forecasts of real economic activity are a critical component of many decisions. Businesses rely on such forecasts in forming their production plans. One financial variable that has been particularly successful in forecasting US real economic growth is the difference between long-term and short-term interest rates, or the yield spread. This chapter defines the yield spread and explains why the spread may be a useful predictor of real economic activity. It describes the data and criteria used to evaluate the predictive power of the yield spread. It examines whether yield spreads have reliably forecast real economic activity in the 11 countries, using several measures of real economic activity and alternative forecast horizons. The results indicate the yield spread is a statistically and economically significant predictor of economic activity in several countries besides the United States. Increases in the yield spread are followed by increases in real economic growth, while decreases in the spread are followed by decreases in growth.

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