Monetary policy

Finance and Economics Discussion Series Divisions of Research & Statistics and Monetary Affairs Federal Reserve Board, Washington, D.C.

Monetary Policy and the Information Content of the Yield Spread

Michael Feroli
2004-44 NOTE: Staff working papers in the Finance and Economics Discussion Series (FEDS) are preliminary materials circulated to stimulate discussion and critical comment. The analysis and conclusions set forth are those of the authors and do not indicate concurrence by other members of the research staff or the Board of Governors. References in publications to the Finance and Economics Discussion Series (other than acknowledgement) should be cleared with the author(s) to protect the tentative character of these papers.

Monetary Policy and the Information Content of the Yield Spread
Michael Feroli∗ Federal Reserve Board Division of Research and Statistics August, 2004

Abstract This paper demonstrates that the ability of the yield spread to predict output fluctuations is contingent on the monetary authority’s reaction function. In particular, expectations of monetary policy actions are crucial for the spread to predict output conditional on the short-rate. Furthermore, numerical experiments suggest that the post-1979 decrease in the yield spread’s predictive power is due to a shift in the monetary policy reaction function at that time. Keywords: Yield Spread, Business Cycles, Monetary Policy. JEL Classification: E37, E43, E52.

The views expressed in this paper are those of the author and do not represent those of the Federal Reserve System or its staff. Corresponding address: 20th St. & Constitution Ave., NW, Mail Stop 80, Washington, D.C. 20551. E-mail:[e-mail]

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Introduction

Following Laurent (1988) and Stock and Watson (1989), a flurry of papers in the early ’90s empirically tested and verified the well-known proposition that a flattening of the yield curve is a strong signal of an impending recession.