A re-examination of the predictability of the yield spread for real economic activity *

James Douglas Hamilton · Dong Heon Kim

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Monetary Policy and Economic Impact Financial Markets and Investment Strategies Market Dynamics and Volatility

Abstract

This paper revisits the yield spread's usefulness for predicting future real GDP growth. We show that the contribution of the spread can be decomposed into the effect of expected future changes in short rates and the effect of the term premium. We find that both factors are relevant for predicting real GDP growth but the respective contributions differ. We account for part of the contribution of the term premium using a logarithmic term structure model with a time-varying variance of the inflation forecast error. We find that the variance of inflation is a significant component of the term premium and part of the reason that the term premium helps predict real GDP growth. . JEL Classification: E32, E37, E43 * We thank Marjorie Flavin, Wouter den Haan, Valerie Ramey and seminar participants at the UCSD macroeconomics workshop for helpful comments. 2 1. Introduction A large literature has examined variables that help predict the business cycle. Interest rates and interest rate spread...

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References

1992ARCH modeling in finance 1983Oil and the Macroeconomy since World War II 2000What is an Oil Shock?1991The Term Structure as a Predictor of Real Economic Activity 1996This is what happened to the oil price-macroeconomy relationship 1998Predicting U.S. Recessions: Financial Variables as Leading Indicators 1994Chapter 49 Arch models 1988The real term structure and consumption growth

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