The Yield Curve, December 2007
Since last month, both long-term and short term interest rates have decreased, with short rates dipping more, leading to a steeper yield curve. 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 had been giving a rather pessimistic view of economic growth for a while now, but with an increasingly steep curve, this is turning around. The spread has remained robustly positive, with the 10-year rate at 4.12 percent and the 3-month rate at 2.92 percent (both for the week ending December 14). Standing at 120 basis points, the spread is up from November's 82 basis points as well as October's 67 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, if a bit on the low side.
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 will be in recession. Looking at that relationship, the expected chance of the economy being in a recession next December is 5 percent, down from November's 9 percent, and October's 14 percent.Perhaps the decreasing chance of a recession 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. In addition, reductions in both the federal funds target rate and the discount rate by the Federal Reserve have had the same effect, as lower rates tend to steepen the yield curve. Furthermore, the forecast is for where the economy will be next December, not earlier in the year.
The 5 percent probability of a recession next December 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, and Econbrowser looks at the probability that 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, 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?”