The Persistence of Consumption and the Leading Indicator Property of the Term Spread

Numerous empirical studies find that the spread between long- and short-term interest rates widens (narrows) prior to economic expansions (contractions), a phenomenon called the leading indicator property of the term spread (LIPTS). However, the theoretical mechanism underlying LIPTS remains obscure. Using a dynamic asset pricing model, this study shows that persistence in consumption fosters inertia in short-term interest rates and explains LITPS qualitatively and quantitatively