Why Can the Yield Curve Predict Output Growth, Inflation, and Interest Rates? An Analysis with an Affine Term Structure Model

The literature provides evidence that term spreads help predict output growth, inflation, and interest rates. This paper integrates and explains these predictability results by using an affine term structure model with observable macroeconomic factors for U.S. data. The results suggest that consumers are willing to pay a higher premium for a consumption hedge during a higher inflation regime. This causes term spreads to react to inflation shocks, which proves useful for prediction. We also find that term spreads using the short end of the yield curve have less predictive power than many other spreads. We attribute this to monetary policy inertia.