Financial-cycle ratios and medium-term predictions of GDP: Evidence from the United States

TL;DR

This study demonstrates that specific financial ratios from housing and firm balance sheets can reliably predict medium-term GDP growth in the US, outperforming complex models across different economic conditions.

Contribution

It identifies and validates simple financial ratios as effective predictors of medium-term GDP, providing a practical forecasting tool grounded in macro-finance theory.

Findings

Housing price-to-rent ratio predicts GDP up to five years ahead.

Liabilities-to-income ratio of non-financial firms improves forecast accuracy.

Simple models outperform complex high-dimensional models.

Abstract

Using a large quarterly macroeconomic dataset for the period 1960-2017, we document the ability of specific financial ratios from the housing market and firms' aggregate balance sheets to predict GDP over medium-term horizons in the United States. A cyclically adjusted house price-to-rent ratio and the liabilities-to-income ratio of the non-financial non-corporate business sector provide the best in-sample and out-of-sample predictions of GDP growth over horizons of one to five years, based on a wide variety of rankings. Small forecasting models that include these indicators outperform popular high-dimensional models and forecast combinations. The predictive power of the two ratios appears strong during both recessions and expansions, stable over time, and consistent with well-established macro-finance theory.