Abstract
This compilation of summaries of Working Papers released during January-June 1993 is being issued as a part of the Working Paper series. It is designed to provide the reader with an overview of the research work performed by the staff during the period. Authors of Working Papers are normally staff members of the Fund or consultants, although on occasion outside authors may collaborate with a staff member in writing a paper. The views expressed in the Working Papers or their summaries are, however, those of the authors and should not necessarily be interpreted as representing the views of the Fund. Copies of individual Working Papers and information on subscriptions to the annual series of Working Papers may be obtained from IMF Publication Services, International Monetary Fund, 700 19th Street, Washington, D.C. 20431. Telephone: (202) 623-7430 Telefax: (202) 623-7201
Do the capital markets contain information relevant for forecasting real output growth? For a long time, academics and the public have believed that the stock market in particular is a good forecasting mechanism. Fischer and Merton (1984), for example, claim that the stock price is the single best predictor of the business cycle. This paper makes the case that the bond market may actually be a better predictor of economic growth than the stock market.
This paper presents a simple model that yields a closed-form formula for the term structure of interest rates. It explicitly demonstrates the link between equilibrium interest rates and the real output process. Then, the paper documents how a term structure variable or, more specifically, the yield spread between long-term and short-term government bonds can be used to forecast GDP growth in the seven major industrial countries.
To evaluate the forecasting performance of the yield curve, the yield spread model is compared with the alternative stock price-based model and a univariate time-series model for GDP growth. It appears that the yield spread outperforms both models for the majority of the countries studied and also retains marginal forecasting power when other relevant information variables are included in the regressions.
These results suggest that it may be useful to add some measure of the term structure to the list of leading indicators, a status that the stock market price index has long enjoyed.