Menzie D. Chinn (University of Wisconsin) - The Predictive Power of the Term Spread and Financial Variables for Economic Activity across Countries

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BOFIT Seminar - Menzie D. Chinn (University of Wisconsin) - The Predictive Power of the Term Spread and Financial Variables for Economic Activity across Countries

Co-author: Laurent Ferrara (SKEMA Business University) 

Abstract:

In recent years, there has been renewed interest in the moments of the yield curve (or alternatively, the term spread) as a predictor of future economic activity, defined as either recessions, or industrial production growth. In this paper, we re-examine the evidence for this predictor for the United States, other high income countries, as well as select emerging market economies (Brazil, India, China, South Africa, and South Korea), over the 1970-2023 period. We examine the sensitivity of the results to the selection of countries, the addition of financial variables that measure other dimensions of financial conditions both domestically and internationally.  Specifically, we account for foreign term spreads (Ahmed and Chinn, 2023), sectorally disaggregated stock market variables (Chatelais, Stalla-Bourdillon and Chinn, 2023), financial conditions indexes (Arrigoni, et al., 2022), and the debt service ratio (Borio, et al., 2020). We find that foreign term spreads and the debt service ratio in many cases yield substantially better predictive power, both in terms of in-sample fit using proportion of variance explained, as well as Receiver Operating Characteristics (ROCs), which measures the proportion of correct predictions at each given threshold. We find that the predictive power of the yield curve, as well as other financial variables, varies across countries, with particularly little explanatory power in emerging market economies.