The (Term) Structure of Interest Rates as a Predictor of Real Economic Growth: An Econometric Analysis for Germany

Abstract

In this article, I investigate interest rate based forecast models for German real economic activity, measured in annual growth rates of real GNP. One might ask why financial variables can be viewed as leading indicators of the business cycle. On financial markets economic agents allocate their consumption intertemporally; thus, the prices on financial markets — interest rates — are regarded as intertemporal prices of purchasing power, which are not only determined by present, but also by (expected) relevant future economic conditions such as the future path of real economic activity. Furthermore, financial markets can react much faster to business cycle relevant information (e.g. from fiscal- or monetary policy) and adjust their prices accordingly, long before the impact is reflected in the business cycle. Therefore, market prices on financial markets are supposed to contain economic agents’ expectations about future economic activity, and hence, if those expectations are systematically correct, can provide a look into the future.

“A third reason economists are interested in the term structure is that it may provide information about the expectations of participants in financial markets. These expectations are of considerable interest to forecasters and policymakers. Market participants’ beliefs about what may happen in the future influence their current decisions; these decisions, in turn, help determine what actually happens in the future.” (Russell 1992, p. 37)