Predictability of Term Spread for Economic Activity with Liquidity Premium Theory

In this article, we explore the predictive content of the term spread based on the liquidity premium theory. We decompose the contribution of the spread into the effect of expected future changes in short rates and the effect of the term premium. We also examine whether the predictive power of the term spread for real economic activity can be enhanced by such a decomposition. The basic finding is that both the expectations effect and the term premium effect are relevant for predicting economic fluctuations. In particular, we find that the decomposition might lead to a better prediction for the business-cycle turning points than the usual term spread.