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The Yield Spread as a Symmetric Predictor of Output and Inflation
Authors: Gikas A. Hardouvelis* and Dimitrios Malliaropulos†
Abstract : We present evidence that the predictive ability of the yield spread for short-run inflation is related to its predictive ability for economic activity. In particular, an increase in the slope of the term structure predicts an increase in output growth and a decrease in inflation of equal magnitude. In order to explain this finding, we develop a monetary asset pricing model with sticky goods prices. Sticky prices imply that economic disturbances generate predictable changes in output and inflation, thus allowing for intertemporal substitution effects and changes in the slope of the yield curve. We derive analytic solutions of the covariance
between the nominal yield spread and future output growth and inflation and show that a moderate degree of price stickiness and relatively high degree of intertemporal substitution can account for the observed correlations in the U.S. Hardouvelis Maliaropulos data over the period 1960:Q1 — 2003:Q2.
JEL: E43, E44.
Keywords: General equilibrium; Term structure of interest rates;
Consumption-CAPM; Asset pricing.
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