Abstract Several studies have established the predictive power of the yield curve for the U.S. and various European countries. In this paper we use data from the European Union (EU15), from 1994:Q1 to 2008:Q3. We use the European Central Bank's euro area yield spreads to predict European real GDP deviations from the long-run trend. We also augment the models tested with non monetary policy variables: the unemployment and a composite European stock price index. The methodology employed is a probit model of the inverse cumulative distribution function of the standard distribution using several formal forecasting and goodness of fit evaluation tests. The results show that the yield curve augmented with the composite stock index has significant forecasting power in terms of the EU15 real output.

Keywords Forecasting * Yield spread * Recession * Probit * Term structure * Monetary policy * Real growth

JEL E43 * E44 * E52 * C53

Introduction

The yield curve, measuring the difference between short and long term interest rates, has been at the center of recession forecasting. The theoretical justification of this line of work is that since short term interest rates are instruments of monetary policy, and long term interest rates reflect market's expectations on future economic conditions, the difference between short and longer term interest rates may contain useful information to policy makers and other individuals for the corresponding time frame. Furthermore, when the yield curve is upward slopping during recessions, it indicates that there are expectations for future economic upturn. On the other hand, just before recessions, the yield curve flattens or even inverts. There are two major branches of empirical work in this area: first, simple OLS estimation where researchers try to predict future economic activity and second, probit models are used to forecast upcoming recessions. The main objective of these two classes of papers is to accommodate the fluctuations of future economic activity taking into account the information that is included in the yield curve and is independent of the exercised monetary policy. According to the influential paper in this line of research by Estrella and Mishkin (1997), the short end of the yield curve can be affected by the European Central Bank or the Federal Reserve or any other central bank, but the long end will be determined by many other considerations, including long term expectations of inflation and future real economic activity. In their paper, after taking into account monetary policy conducted in four major European countries (France, Germany, Italy and the U.K.), Estrella and Mishkin (1997) show that the term structure spread has significant predictive power for both real activity and inflation. Bonser-Neal and Morley (1997), after examining eleven developed economies, found that the yield spread is a good predictive instrument for future economic activity. In the same vein, Venetis et al. (2003) reached the same conclusions, as did Hamilton and Kim (2002). On the other hand, Kim and Limpaphayom (1997) tested Japan and found evidence that the expected short term interest rate is the only source of predictability for Japan, and not the term premium. Ang et al. (2006), after modeling regressor endogenecity and using data for the period 1952 to 2001, conclude that the short term interest rate has more predictive power than any term spread. They confirm their finding by forecasting GDP out of sample. There is also a class of papers that uses probit models to forecast recessions. Wright (2006), using as explanatory variables the Federal Reserve funds rate and the term spread, forecasts recessions six quarters ahead for the U.S. economy. Chauvet and Potter (2001) propose out-of-sample forecasting using standard probabilities and "hitting probabilities" of recession that take into account the length of the business cycle phases. They found that standard probit specification that does not consider the presence of autocorrelated errors and that has time varying parameters due to existence of multiple breakpoints tends to over-predict recession results. …