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

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.