Can the Term Spread Predict Output Growth and Recessions? A Survey of the Literature by ProQuest

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									              Can the Term Spread Predict Output Growth
                and Recessions? A Survey of the Literature
                                                                                      David C. Wheelock and Mark E. Wohar

                    This article surveys recent research on the usefulness of the term spread (i.e., the difference
                    between the yields on long-term and short-term Treasury securities) for predicting changes in
                    economic activity. Most studies use linear regression techniques to forecast changes in output
                    or dichotomous choice models to forecast recessions. Others use time-varying parameter models,
                    such as Markov-switching models and smooth transition models, to account for structural changes
                    or other nonlinearities. Many studies find that the term spread predicts output growth and reces-
                    sions up to one year in advance, but several also find its usefulness varies across countries and
                    over time. In particular, many studies find that the ability of the term spread to forecast output
                    growth has diminished in recent years, although it remains a reliable predictor of recessions.
                    (JEL C53, E37, E43)

                    Federal Reserve Bank of St. Louis Review, September/October 2009, 91(5, Part 1), pp. 419-40.




I
      nformation about a country’s future eco-                                spread might predict future economic activity and
      nomic activity is important to consumers,                               then surveys empirical studies that investigate
      investors, and policymakers. Since Kessel                               how well the spread predicts output growth and
      (1965) first discussed how the term struc-                              recessions. The survey describes the data and
ture of interest rates varies with the business                               methods used in various studies to investigate
cycle, many studies have examined whether the                                 the predictive power of the term spread, as well
term structure is useful for predicting various                               as key findings. In general, the literature has not
measures of economic activity. The term spread                                reached a consensus about how well the term
(the difference between the yields on long-term                               spread predicts output growth. Although many
and short-term Treasury securities) has been                                  studies do find that the spread predicts output
found useful for forecasting such variables as                                growth at one-year horizons, studies also find
output growth, inflation, industrial production,                              considerable variation across countries and over
consumption, and recessions, and the ability                                  time. In particular, many studies find that the abil-
of the spread to predict economic activity has                                ity of the spread to forecast output growth has
become something of a “stylized fact” among                                   declined since the mid-1980s. The empirical lit-
macroeconomists.                                                              erature provides more consistent evidence that
    This article surveys recent research investi-
                                                                              1
gating the ability of the term spread to forecast                                 Surveys of the older literature include Berk (1998), Dotsey (1998),
                                                                                  Estrella and Hardouvelis (1991), Plosser and Rouwenhorst (1994),
output growth and recessions.1 The article briefly                                and Stock and Watson (2003). Stock and Watson (2003) also survey
discusses theoretical explanations for why the                                    research on the usefulness of asset prices for forecasting inflation.


   David C. Wheelock is a vice president and economist at the Federal Reserve Bank of St. Louis. Mark E. Wohar is a professor of economics at
   the University of Nebraska at Omaha. The authors thank Michael Dueker, Massimo Guidolin, and Dan Thornton for comments on a previous
   draft of this article. Craig P. Aubuchon provided research assistance.

   © 2009, The Federal Reserve Bank of St. Louis. The views expressed in this article are those of the author(s) and do not necessarily reflect the
   views of the Federal Reserve System, the Board of Governors, or the regional Federal Reserve Banks. Articles may be reprinted, reproduced,
   published, distributed, displayed, and transmitted in their entirety if copyright notice, author name(s), and full citation are included. Abstracts,
   synopses, and other derivative works may be made only with prior written permission of the Federal Reserve Bank of St. Louis.



F E D E R A L R E S E R V E B A N K O F S T . LO U I S R E V I E W                            S E P T E M B E R / O C TO B E R , PA R T 1   2009   419
Wheelock and Wohar



 Figure 1
 U.S. Term Spread and Recessions

                          Percent
         
								
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