This is a significantly revised version of Osaka University of Economics Working Paper No. 2008-2 titled "Durability in Consumption and the Predictive Power of the Yield Curve."

Numerous empirical studies find that the spread between long- and short-term interest rates widens (narrows) prior to economic expansions (contractions), a phenomenon called the leading indicator property of the term spread (LIPTS). However, the theoretical mechanism underlying LIPTS remains obscure. Using a dynamic asset pricing model, this study shows that persistence in consumption fosters inertia in short-term interest rates and explains LITPS qualitatively and quantitatively.