ARE FINANCIAL SPREADS USEFUL INDICATORS OF FUTURE INFLATION AND OUTPUT GROWTH IN EU COUNTRIES

This paper seeks to address the policy issue of the usefulness of fina ncial spreads as indicators of future inflation and output growth in t he countries of the European Union, placing a particular focus on out- of-sample forecasting performance. Such analysis is of considerable re levance to monetary authorities, given the breakdown of the money/inco me relation in a number of countries and following increased emphasis of domestic monetary policy on control of inflation following the broa dening of the ERM bands. The results confirm that far some countries, financial spread variables do contain some information about future ou tput growth and inflation, with the yield curve and the reverse yield gap performing best. However, the relatively poor out-of-sample foreca sting performance and/or parameter instability suggests that the need for caution in using spread variables for forecasting in EU countries. Only a small number of spreads contain information, and improve forec asting in a manner which is stable over time. (C) 1997 John Wiley & So ns, Ltd.