Predicting real growth and inflation with the yield spread

Analysts often use financial variables to help predict real activity and inflation. One of the most popular of these variables is the spread between yields on long-term and short-term government instruments, also known as the yield spread. Researchers have shown the spread is a good predictor of real activity. For instance, in a recent issue of the Economic Review, Bonser-Neal and Morley found that the spread helps predict real activity over the next year, the next two years, and the next three years.> Kozicki examines the predictive power of the yield spread for real growth and inflation in a collection of industrialized countries. She extends the analysis of Bonser-Neal and Morley by examining in greater detail the horizons at which the yield spread helps predict real growth and by investigating whether information on the level of yields contains additional predictive power beyond that summarized by the spread. She also adds to the existing literature by examining a broader collection of countries than has previously been analyzed and a wider array of forecast horizons. In addition, restrictions imposed in earlier studies are relaxed.> For real activity, Kozicki finds that the predictive power of the yield spread largely derives from its usefulness over horizons of a year or so and generally dominates the predictive power associated with the level of yields. For inflation, although the yield spread helps predict inflation at moderate horizons of a few years, the level of yields is a more useful predictor of inflation.