Allison K. Rodean

Massimo Guidolin

English

Research Papers in Economics

July 2007 InternationalEconomicTrends
Views expressed do not necessarily reflect official positions of the Federal Reserve System.
L
ong-term interest rates are usually higher than short-
term interest rates; thus, the difference between the
two rates, the term spread, is usually positive. Over
the past 20 years, for most developed countries, a negative
term spread tended to precede a recession approximately
three quarters later.1 One reason for this predictability might
be that the negative term spread results from monetary
tightening, a rise in short-term interest rates. These high
short rates in turn produce an economic slowdown.
The United States, however, has recently observed a low
(sometimes negative) term premium with no recession. For
most of 2005 and all of 2006, the average term spread
between the yield of 10-year constant-maturity Treasury
bonds and of 3-month Treasury bills was only 35 basis points,
compared with its historical average of 142 basis points.
Surprisingly, during this time U.S. real GDP maintained 3
percent growth per year. Has the term spread stopped accu-
rately forecasting recessions?
The chart shows the relationship for G7 countries between
a negative term spread and real GDP growth three quarters
later. If a negative term spread predicted a recession, all the
data points would fall in the bottom panel.
Clearly this is not the case: Less than one
quarter of the points fall in the bottom panel.
The predictive power of the term spread
has deteriorated even further since the
1990s. By dividing the data into two time
frames (i.e., pre- and post-1995), we show
that for the data since 1995 (red squares) a
negative term spread has rarely forecasted a
recession three quarters in advance. In fact,
in the most recent 12 years, a negative term
spread has predicted a recession correctly
in only one quarter.
The reasons why the forecasting power
of the yield curve has deteriorated remain
unclear. Some economists have argued that
this relationship may depend on the types of
shocks affecting the economy (e.g., supply
shocks from oil prices vs. demands shocks
from increased consumption).2 Other econ-
omists have argued that globalization has affected the econ-
omy in which the Federal Reserve (and, as of late, the
European Central Bank) has successfully pursued price-
stability goals: It may be that low inflation along with sus-
tained growth can be achieved with weaker and less-frequent
changes in the term spread. In any event, the poor recent
predictive power of the term spread lessens the fear that the
current low/negative spread in the United States portends a
recession in the near future (although it is important to note
that the chart shows data for seven countries with rather
heterogeneous macroeconomic conditions over the past 50
years). The term spread has simply stopped speaking (i.e.,
forecasting recessions) to policymakers everywhere around
the world.
—Massimo Guidolin and Allison K. Rodean
1 We define recession as two or more consecutive quarters of negative real GDP
growth. The G7 countries (discussed below) are Canada, France, Germany, Italy,
Japan, the United Kingdom, and the United States.
2 Smets, Frank and Tsatsaronis, Kostas. “Why Does the Yield Curve Predict
Economic Activity? Dissecting the Evidence for Germany and the United
States.” CEPR Discussion Paper No. 1758, Centre for Economic Policy
Research, 1997.
Is the Term Spread Still Speaking to
Policymakers? Some International Evidence
research.stlouisfed.org
–3.00
–2.00
–1.00
0.00
1.00
2.00
3.00
4.00
5.00
–6.00 –5.00 –4.00 –3.00 –2.00 –1.00 0.00
Term Spread (%)
GDP Growth Rate (3Q ahead)
Before 1995
After 1995
Annual Edition

Is the term spread still speaking to policymakers? some international evidence

http://research.stlouisfed.org/publications/aiet/20070701/cover.pdf

Is the term spread still speaking to policymakers? some international evidence

Abstract

Similar works

Full text

Available Versions

Research Papers in Economics