Forecasting US interest rates and business cycle with a nonlinear regime switching VAR model

This paper introduces a regime switching vector autoregressive model with time†varying regime probabilities, where the regime switching dynamics is described by an observable binary response variable predicted simultaneously with the variables subject to regime changes. Dependence on the observed binary variable distinguishes the model from various previously proposed multivariate regime switching models, facilitating a handy simulation†based multistep forecasting method. An empirical application shows a strong bidirectional predictive linkage between US interest rates and NBER business cycle recession and expansion periods. Due to the predictability of the business cycle regimes, the proposed model yields superior out†of†sample forecasts of the US short†term interest rate and the term spread compared with the linear and nonlinear vector autoregressive (VAR) models, including the Markov switching VAR model.