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Why Can the Yield Curve Predict Output Growth, Inflation, and Interest Rates? An Analysis with an Affine Term Structure Model*1

July 2004
Hibiki Ichiue*2

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  • *1 I am especially grateful to my dissertation advisor, James D. Hamilton for his valuable support and comments. I would like to thank Marjorie Flavin, Bruce Lehmann, Alan Timmermann, Keiichi Tanaka, Nobuyuki Oda, Akira Ieda and participants in the presentations at UCSD and the Bank of Japan. I am also grateful to Monica Piazzesi for answering my questions on her papers. The views expressed here are those of the author, and not necessarily of the Bank of Japan.
  • *2 Address: 2-1-1 Nihonbashi-Hongokucho Chuo-ku Tokyo 103-8660 Japan
    Tel.: +81-3-3279-1111 (Bank of Japan), Fax: +81-3-5255-6758, E-mail address: hibiki.ichiue@boj.or.jp

Abstract

The literature provides evidence that term spreads help predict output growth, inflation, and interest rates. This paper integrates and explains these predictability results by using an affine term structure model with observable macroeconomic factors for U.S. data. The results suggest that consumers are willing to pay a higher premium for a consumption hedge during a higher inflation regime. This causes term spreads to react to inflation shocks, which proves useful for prediction. We also find that term spreads using the short end of the yield curve have less predictive power than many other spreads. We attribute this to monetary policy inertia.

JEL classification:
E43; E52

Keywords:
Term structure, Monetary policy, VAR