Long-term prediction of the United States’ recession through trend decomposition of interest rate term Spread

This study analyzes whether the trend obtained by decomposing the expected portion of the interest rate term spread into risk premium shock and monetary policy shock is useful for longterm forecasts of the United States’ recession. After the Beverage Nelson decomposition of the interest rate term spread from the co-integrated VAR model composed of short-term and long-term interest rates, the monetary policy and independent risk premium shocks’ trends are estimated and used for the prediction. Using linear and probit prediction models, we test whether these trends are effective for the predictive power enhancement of output gap and recession. Based on the proposed process, United States data were analyzed through the probit model and FM-OLS estimation. We found that the trends of monetary policy shock and risk premium shock clearly have an edge for long-term forecast compared with conventional term spread forecasts.