Utilizing Financial Market Information in Forecasting Real Growth, Inflation and Real Exchange Rate

Abstract

Based on an extension of the Gordon (1962) growth model we propose a simple approach to forecasting real growth, inflation and real exchange rate. The extension is rooted in introducing the Fisher (1930) and Euler equations, and in the open economy context, also the purchasing power parity (PPP) and the uncovered interest rate parity (UIP) relations to the analysis. Based on these equilibrium conditions as the final form we suggest a forecasting system of three simple equations, all based on current financial market information in the form of dividend yields and short-term interest rate. Our empirical results based on standard time series analytical tools indicate that the role of simple financial market information both in the forms of dividend yields and nominal interest rate is highly important for forecasting out-of-sample the time-varying underlying trends in the macroeconomic data for the U.K., Euro-zone and Japan, and treating the U.S. as the world market. Our results strongly stress the importance of including some measure of stock market performance in macroeconomic forecasting systems, especially during turbulent time periods in the financial market and macro economy.