Why Does the Yield Curve Predict Economic Activity?: Dissecting the Evidence for Germany and the United States

Posted: 13 Dec 2005

See all articles by Frank Smets

Frank Smets

European Central Bank (ECB); KU Leuven - Center for Economic Studies

Kostas Tsatsaronis

Bank for International Settlements (BIS) - Monetary and Economic Department

Date Written: December 1997

Abstract

This paper investigates why the slope of the yield curve predicts future economic activity in Germany and the United States. A structural VAR is used to identify aggregate supply, aggregate demand, monetary policy and inflation scare shocks and to analyze their effects on the real, nominal and term premium components of the term spread and on output. In both countries demand and monetary policy shocks contribute to the covariance between output growth and the lagged term spread, while inflation scares do not. As the latter are more important in the United States, they reduce the predictive content of the term spread in that country. However, the main reason for the stronger leading indicator property in Germany is the positive contribution of supply shocks, which owing to a different monetary policy response explains about half of the positive covariance at lag four in Germany and almost nothing in the United States.

JEL Classification: E43, E44, E58

Suggested Citation

Smets, Frank and Tsatsaronis, Konstantinos, Why Does the Yield Curve Predict Economic Activity?: Dissecting the Evidence for Germany and the United States (December 1997). BIS Working Paper No. 49, Available at SSRN: https://ssrn.com/abstract=101411

Frank Smets

European Central Bank (ECB) ( email )

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KU Leuven - Center for Economic Studies ( email )

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Konstantinos Tsatsaronis (Contact Author)

Bank for International Settlements (BIS) - Monetary and Economic Department ( email )

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Switzerland
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