The Term Spread and GDP Growth in Australia

This paper analyses the effectiveness of the spread between short and long term interest rates for predicting GDP growth in Australia, and whether the predictive relation deteriorates, as theory suggests, with the adoption of a credible inflation-targeting regime. We test whether predictive power is sensitive to inclusion of other conditioning variables which may be useful in forecasting GDP growth, and whether forecasting significance is due primarily to the expected change in short-term interest rates, the term premium, or a combination of the two. In a simple bivariate model, results strongly suggest that the shift to a credible inflation-targeting regime has reduced the predictive content of the term spread. However, extensions to this basic model tend to undermine this result. The predictive power of the term spread in Australia may have been oversold.