Developments in Macro-Finance Yield Curve Modelling: The predictive content of the yield curve for inflation

Abstract

We revisit the common practice of using yield spreads to forecast inflation. We address two main issues. First, we assess the importance of decomposing yield spreads into an expectations and a term premium component in order to predict inflation. Second, we quantify the impact of financial shocks in the dynamics of each of these components. The yield spread decomposition is achieved with the use of a no-arbitrage macro- finance model incorporating both macroeconomic and financial factors. The model is applied to the U.S. economy and estimated with Bayesian techniques. We find that the yield spread decomposition is crucial to forecast inflation for most forecasting horizons. Also, the inclusion of control variables such as the short-term interest rate and lagged dependent variable does not drive out the predictive power of the yield spread decomposition.