Abstract
A re-evaluation of the role of interest rates is necessary in the wake of the Great Recession. This paper will re-evaluate the interpretation and empirical use of the yield spread as a predictor of recessions, focusing on the simplified methodology in a New York Federal Reserve Bank paper by Estrella and Trubin. Using the user cost difference formula to calculate bond prices following the methodology in the Divisia literature begun by William A. Barnett and a unique data set from the Center for Financial Stability, the yield spread is shown to be a form of the user cost difference, and use of the user cost is shown to marginally improve the predictive abilities of the yield spread. Further research into this view of the link of interest rates and economic activity is proposed.
Highlights
In the wake of the 2008–2009 financial crisis and great recession, short term yields pushed down to the zero lower bound
The yield spread will be demonstrated be a form of a Divisia user cost difference, which when used as a recession prediction in the same simple manner as Estrella and Trubin (2006) shows improved predictability
By considering the spread as part of a user cost of the store of value service of differing maturity bonds, the relationship between the inversion of price differences and recessions can be explained by supply and demand behavior among substitutes
Summary
In the wake of the 2008–2009 financial crisis and great recession, short term yields pushed down to the zero lower bound. The lack of information produced by the Federal Reserve’s preferred intermediate targets for monetary policy left ambiguity regarding the effectiveness of lower short term interest rates as indicators of monetary easing, while Divisia monetary aggregates demonstrated a clear contraction throughout 2009 and into 2010 (see Barnett et al (2012) and Belongia and Ireland (2012)). The yield spread will be demonstrated be a form of a Divisia user cost difference, which when used as a recession prediction in the same simple manner as Estrella and Trubin (2006) shows improved predictability. Further the interpretation of the inverted difference between the user cost price lends credence to the liquidity preference outcome, and places the yield spread inversion in a more intuitive microeconomic context of supply and demand determining price differences
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