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short essays and reports on the economic issues of the day
2007 ■ Number 16

Is the Term Spread Still Speaking to Policymakers?
Some International Evidence
Massimo Guidolin and Allison K. Rodean
ong-term interest rates are usually higher than shortterm interest rates; thus, the difference between the two
rates, the term spread, is usually positive. Over the past
20 years, for most developed countries, a negative term spread
tended to precede a recession approximately three quarters
later.1 One reason for this predictability might be that the negative term spread results from monetary tightening, a rise in
short-term interest rates. These high short rates in turn produce an economic slowdown.
The United States, however, has recently observed a low
(sometimes negative) term premium with no recession. For
most of 2005 and all of 2006, the average term spread between
the yield of 10-year constant-maturity Treasury bonds and of
3-month Treasury bills was only 35 basis points, compared
with its historical average of 142 basis points. Surprisingly,
during this time U.S. real GDP maintained 3 percent growth
per year. Has the term spread stopped accurately forecasting
The chart shows the relationship for G7 countries between
a negative term spread and real GDP growth
three quarters later. If a negative term spread
predicted a recession, all the data points would
fall in the bottom panel. Clearly this is not the
case: Less than one quarter of the points fall
Before 1995
in the bottom panel. The predictive power of
After 1995
the term spread has deteriorated even further
since the 1990s. By dividing the data into two
time frames (i.e., pre- and post-1995), we show
that for the data since 1995 (blue squares) a
negative term spread has rarely forecasted a
recession three quarters in advance. In fact,
in the most recent 12 years, a negative term
spread has predicted a recession correctly in
only one quarter.
The reasons why the forecasting power of
the yield curve has deteriorated remain
unclear. Some economists have argued that
this relationship may depend on the types of
shocks affecting the economy (e.g., supply


shocks from oil prices vs. demands shocks from increased
consumption).2 Other economists have argued that globalization has affected the economy in which the Federal Reserve
(and, as of late, the European Central Bank) has successfully
pursued price-stability goals: It may be that low inflation along
with sustained growth can be achieved with weaker and lessfrequent changes in the term spread. In any event, the poor
recent predictive power of the term spread lessens the fear that
the current low/negative spread in the United States portends
a recession in the near future (although it is important to note
that the chart shows data for seven countries with rather heterogeneous macroeconomic conditions over the past 50 years).
The term spread has simply stopped speaking (i.e., forecasting
recessions) to policymakers everywhere around the world. ■

We define recession as two or more consecutive quarters of negative real GDP
growth. The G7 countries (discussed below) are Canada, France, Germany, Italy,
Japan, the United Kingdom, and the United States.


Smets, Frank and Tsatsaronis, Kostas. “Why Does the Yield Curve Predict
Economic Activity? Dissecting the Evidence for Germany and the United States.”
CEPR Discussion Paper No. 1758, Centre for Economic Policy Research, 1997.

GDP Growth Rate (3Q ahead)




Term Spread (%)

Views expressed do not necessarily reflect official positions of the Federal Reserve System.