A Divisia User Cost Interpretation of the Yield Spread Recession Prediction

Abstract

A re-evaluation of the role of interest rates is necessary in the wake of the Great Recession. This paper will re-evaluate the interpretation and empirical use of the yield spread as a predictor of recessions, focusing on the simplified methodology in a New York Federal Reserve Bank paper by Estrella and Trubin. Using the user cost difference formula to calculate bond prices following the methodology in the Divisia literature begun by William A. Barnett and a unique data set from the Center for Financial Stability, the yield spread is shown to be a form of the user cost difference, and use of the user cost is shown to marginally improve the predictive abilities of the yield spread. Further research into this view of the link of interest rates and economic activity is proposed.