Indicator models for the prediction of real activity and inflation have recently received increasing attention. A major reason for this renewed interest in indicator methods is the perceived failure of structural macroeconomic models in many countries to forecast the recent falls in, and indeed the subsequent increases in, output. Structural models are widely thought to be particularly bad at predicting turning points. Considerations such as these are at the center of the influential work by Stock and Watson (1989), whose indicator model is expressedly designed to predict turning points. Generally, indicator models are “nonstructural” approaches to prediction, so that where monetary indicators, for example, are used, they are not based on an explicit model of the transmission mechanism of monetary policy. This avoidance of specific structural hypotheses may indeed be an advantage of indicator models since it avoids the strictures of Sims (1980), who argued that structural models apply “incredible” identification restrictions.
Recent work on indicator models has focused on the possibility that there is advance information in financial markets, so that movements in financial spreads give early warnings of changes in activity and inflation.
The aim of this paper is to provide an extensive empirical evaluation of spreads as indicators, by comprehensively testing them to predict output and inflation. The tests are done using nonstructural Vector-Auto Regressive (VAR) models, which are initially quite large (six equation models are used), so that a significant amount of information is used before including the financial spreads. The tests are thus directed at whether the financial spreads add to the explanatory power of what is already a fairly extensive model.
The paper first discusses a priori reasons for using financial spreads as indicators of changes in both real and nominal aggregates. Then Section II presents the empirical results for the United Kingdom and Germany, and Section III concludes.
Bernanke, Ben, and Mark Gertler, “Agency Costs, Net Worth, and Business Fluctuations,” American Economic Review, Vol. 79 (March 1989), pp. 14–31.
Davis, E.P., and S.G.B. Henry, “The Use of Financial Spreads as Indicator Variables: Evidence for the U. K. and Germany,” IMF Working Paper 94/31 (Washington: International Monetary Fund, 1994).
Davis, E.P., S.G.B. Henry, and B. Pesaran, “The Role of Financial Spreads; Empirical Analysis of Spreads and Real Activity” (Manchester: forthcoming in The Manchester School, 1994).
Stock, James H., and Mark W. Watson, “New Indexes of Coincident and Leading Economic Indicators,” in NBER Macroeconomics Annual 1989, ed. by Olivier Jean Blanchard and Stanley Fischer (Cambridge, Massachusetts: MIT Press, 1989), pp. 351–94.
E.P. Davis is an economist at the European Monetary Institute. S.G.B. Henry is an Advisor in the IMF’s European I Department.