The mild recession that struck some advanced economies in 2000-2001 led to a revived interest in the study and management of economic cycles. More recently, monetary policy has attracted renewed attention as policymakers face increased pressure to anticipate economic fluctuations.
Gathering information on current and future economic conditions has become an important role of the Central Bank in order to take timely decisions and avoid lags in policy effectiveness. As a consequence, emphasis is being placed on the detection of variables that forecast the future evolution of the economy.
Traditional predictors of future economy, such as monetary aggregates, exchange rates or discount rates, can all be problematic, thus leading to a renewed interest in term spreads, or, in other words, the difference between long-term and short-term rates of interest.
In his article published in the Journal of Economics and Business, Javier Gómez Biscarri, senior lecturer in IESE's managerial economics department, examined the prediction power of term spreads for recession forecasting.
While previous studies have looked at term spreads in the United States, Canada, Germany and Britain, little data is available on the predictive power of term spreads for most European countries. To this end, Gómez studied the informational content of domestic term spreads for a wider set of European Union countries as well as for the United States, focusing on whether this informational content had changed over the past two decades and analyzing those changes.
Signals Becoming Weaker
Gómez finds low and disappearing informational power of domestic spreads; lack of regular predictive power in international spreads; and little informational power of alternative financial variables. Given this, he poses the question as to whether accurate predictions can still be carried out.
The article shows that there is still some scope for using spreads as predictors of economic activity, and that in most countries the term spreads give advanced signals about future economic activity. These signals, however, are becoming more and more short-term and weaker.
According to the author, during the 1980s it was mostly domestic spreads that could be used for prediction of economic conditions in Europe, whereas in the 1990s this power has been lost, and most of the information can be obtained from international spreads, for example, from Germany and the United States.
More Integration, Less Predictive Power
"The predictive power of spreads seems to go through two stages: As the domestic financial and monetary systems develop, the spread becomes informative, but a more profound integration leads to a disappearance of the predictive power of the domestic spread, usually in favor of some international spread that, in any case, ends up having weak predictive power," Gómez states.
The findings are interpreted in the paper as stemming from the more intense integration of international economies, which may be both facilitating the transmission of real shocks across countries and limiting the scope for independent domestic monetary policies.
The results suggest that European economies have become more integrated with the American one, which may be leading to a monetary policy that is faster in affecting the real economy - but less effective.
Gómez closes his article with a question that arises regarding the cause of this lower effectiveness: Is it that the more intense international integration places constraints on domestic monetary policy? Or is it that monetary policy - whose effectiveness relies on the existence of nominal frictions - is less effective in developed economies where nominal rigidities are being overcome?