The Yield Curve, January 2008
Since last month, both long-term and short term interest rates have decreased, with short rates dipping more, leading to a steeper yield curve. One reason for noting this is that the slope of the yield curve has achieved some notoriety as a simple forecaster of economic growth. The rule of thumb is that an inverted yield curve (short rates above long rates) indicates a recession in about a year, and yield curve inversions have preceded each of the last six recessions (as defined by the NBER). Very flat yield curves preceded the previous two, and there have been two notable false positives: an inversion in late 1966 and a very flat curve in late 1998. More generally, though, a flat curve indicates weak growth, and conversely, a steep curve indicates strong growth. One measure of slope, the spread between 10-year bonds and 3-month T-bills, bears out this relation, particularly when real GDP growth is lagged a year to line up growth with the spread that predicts it.
The yield curve has continued getting steeper, although both short and long rates have falled recently. The spread remains positive, with the 10-year rate at 3.58 percent, while the 3-month rate jumped down to 2.31 percent (both for the week ending January 25). Standing at 127 basis points, the spread is above December's 120 basis points and November's 82 basis points. Projecting forward using past values of the spread and GDP growth suggests that real GDP will grow at about a 2.6 percent rate over the next year. This is broadly in the range of other forecasts.
While such an approach predicts when growth is above or below average, it does not do so well in predicting the actual number, especially in the case of recessions. Thus, it is sometimes preferable to focus on using the yield curve to predict a discrete event: whether or not the economy is in recession. Looking at that relationship, the expected chance of the economy being in a recession next January stands at 4.8 percent, down a bit from December's 5 percent and November's 9 percent.
The probability of recession is below several recent estimates, and perhaps seems strange in the midst of recent financial concerns, but one aspect of those concerns has been a flight to quality, which lowers Treasury yields, and a reduction in both the federal funds target rate and the discount rate by the Federal Reserve, which tends to steepen the yield curve. Furthermore, the forecast is for where the economy will be next January, not earlier in the year.
The 4.8 percent given by our approach is close to the 9.5 percent calculated by James Hamilton over at Econbrowser (though we are calculating different events: Our number gives a probability that the economy will be in recession a year from now; Econbrowser looks at the probability that the quarter the second quarter of 2007 was in a recession.)
Of course, it might not be advisable to take this number quite so literally, for two reasons. First, this probability is itself subject to error, as is the case with all statistical estimates. Second, other researchers have postulated that the underlying determinants of the yield spread today are materially different from the determinants that generated yield spreads during prior decades. Differences could arise from changes in international capital flows and inflation expectations, for example. The bottom line is that yield curves contain important information for business cycle analysis, but, like other indicators, they should be interpreted with caution.
For more detail on these and other issues related to using the yield curve to predict recessions, see the Commentary “Does the Yield Curve Signal Recession?”