ABSTRACT

Several studies have established the predictive power of the yield curve, ie: the difference between long and short term bond rates, in terms of real economic activity, for the and various European countries. In this paper we use data from the European Union after the introduction of the common currency, the euro, ranging from January 2002 to September 2008. The monthly real industrial production index is used as a proxy for real economic activity and several long and short European Central Bank bond interest rates are used as alternative measures of the spread. We employ simple regression models to test the forecasting ability of the yield spread regarding real economic activity, and probit models to produce in-sample probabilities of recession. The forecasted horizons range from 1 to 12 months ahead. To test whether the yield spread has predictive power independent of the monetary policy applied, we augment the regression models with ECB monetary aggregates. We show that the yield curve can be a simple and accurate tool that can be used in guiding European monetary policy.