The term structure of interest rates and economic activity: an empirical critique

 

Intertemporal asset pricing models, relating macroeconomic variables to asset returns and the term structure of interest rates, suggest that the term structure (yield curve) contains forecast-enhancing information about the future growth rate of real economic activity. Empirical evidence that the term structure contains information regarding a variety of macroeconomic variables has been presented in the literature over the last two decades. Recent empirical studies on the information content of the yield spread have been conducted using simple linear univariate forecasting models. U.S and G7 data have been found to support a leading association between the term structure of interest rates and changes in the level of future real economic activity. However, many of the econometric models presented in the literature are far from adequate; in particular, several empirical studies of the term structure have not adequately accounted for important explanatory variables. The purpose of the paper is to evaluate the significance of these empirical models. Published empirical research is evaluated in the light of the data used, choice of both dependent and explanatory variables, important omited explanatory variables, type of model chosen, economic hypotheses tested, methods of estimation and calculation of standard errors for inference (including generated regressors), reported descriptive statistics, use of diagnostic tests of auxiliary assumptions, use of nested and non-nested tests and information criteria, and empirical implications.

Keywords: Asset pricing, Econometric modelling, Interest rates, Term structure, Forecasting