Predicting Economic Activity with Financial Market Data in a Small Open Economy: Revisiting Stylized Facts During Economic Turbulence

Abstract

Purpose

This paper examines the predictive content of financial variables above and beyond past GDP growth in a small open economy in the Eurozone. We aim to clarify potential differences in forecasting economic activity during periods of steady growth and economic turbulence.

Design/methodology/approach

The out-of-sample forecasting analysis is conducted recursively for two different time periods: the steady growth period from 2004:1 to 2007:4 and the financial crisis period from 2008:1 to 2011:2.

Findings

Our results from Finland suggest that the proper choice of forecasting variables relates to general economic conditions. During steady economic growth, the preferable financial indicator is the short-term interest rate combined with past growth. However, during economic turbulence, the traditional term spread and stock returns are more important in forecasting GDP growth.

Research limitations/implications

The results highlight the importance of long-term interest rates in determining the level of the term spread when the central bank implements a zero interest rate policy. Moreover, during economic turbulence, stock markets are able to signal the expected effects of unconventional monetary policy on GDP growth.

Citation

Kuosmanen, P. and Vataja, J. (2014), "Predicting Economic Activity with Financial Market Data in a Small Open Economy: Revisiting Stylized Facts During Economic Turbulence", Macroeconomic Analysis and International Finance (International Symposia in Economic Theory and Econometrics, Vol. 23), Emerald Group Publishing Limited, Leeds, pp. 217-234. https://doi.org/10.1108/S1571-038620140000023008