Working Paper: CEPR ID: DP1758
Authors: Frank Smets; Kostas Tsatsaronis
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 analyse 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.
Keywords: term structure of interest rates; information content; monetary policy; Germany; United States
JEL Codes: E43; E44; E58
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| aggregate supply shocks (E00) | term spread (C41) |
| aggregate demand shocks (E00) | term spread (C41) |
| monetary policy shocks (E39) | term spread (C41) |
| inflation scare shocks (E31) | term spread (C41) |
| aggregate supply shocks (E00) | output growth (O40) |
| aggregate demand shocks (E00) | output growth (O40) |
| monetary policy shocks (E39) | output growth (O40) |
| term spread (C41) | output growth (O40) |
| demand shocks (E39) | covariance(output growth, lagged term spread) (O40) |
| monetary policy shocks (E39) | covariance(output growth, lagged term spread) (O40) |
| supply shocks (E39) | covariance(term spread, output growth) in Germany (E23) |
| supply shocks (E39) | covariance(term spread, output growth) in United States (E23) |