The Yield Curve, January 2009
In the midst of all the depressing news about the economy, the yield curve might provide a slice of optimism. Not everyone sees it that way, however. Nobel prize winner and New York Times columnist Paul Krugman disagreed with our assessment last month of the yield curve's implications for economic growth.
So what's the argument about? Many financial analysts have come to view the slope of the yield curve (the difference between long and short rates) as a simple forecaster of economic growth. Krugman questions how well it does so in the current financial environment.
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 seven recessions (as defined by the NBER ). In particular, the yield curve inverted in August 2006, a bit more than a year before the current recession started in December 2007. There have been two notable false positives: an inversion in late 1966, and a very flat curve in late 1998. More generally, 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.
Professor Krugman thinks the zero bound on nominal interest rates makes the current prediction suspect, at best. He argues that since short rates can't go down any further, long rates - as (more or less) the average of expected short rates - have to be above current short rates. This is a good point, but not decisive, for two reasons.
First, we don't know for sure that the information content of the yield curve represents solely the expectations of future short rates - it might include a residual component of the long rate, sometimes called the risk premium. Also, the length of time short rates remain low will affect the level of long rates - which means that higher long rates could indicate that market participants see an improving economy, with short rates moving up relatively soon.
Secondly, Krugman points out that in Japan, the yield curve had a positive slope all through its "lost decade." Another good point, but it's not clear that Japan's situation is all that comparable with that of the United States. Has Japan's yield curve been a useful predictor of economic growth, even outside zero-bound times? In the U.S., the yield curve has been a good predictor of growth, even going back to the 19th century (as pointed out here). The curve's forecasting power is more than just as a predictor of where the Fed will move the federal funds rate, because it worked even before there was a Fed. Still, given it is a statistical relationship (however robust), we can't be sure why it works, or the circumstances under which it won't.
Though the slope of the yield curve has flattened since last month, with long rates falling and short rates inching up, the difference between them remained strongly positive. The 3-month rate edged up from the miniscule 0.02 percent to a still tiny 0.11 percent (for the week ending January 9). The 10-year rate dropped from 2.67 percent to 2.48.
Consequently, the slope decreased to 237 basis points, down from December's 265 basis points and November's 331. The flight to quality, the zero bound, and the turmoil in the financial markets may impact the reliability of the yield curve as an indicator, but projecting forward using past values of the spread and GDP growth suggests that real GDP will grow at about a 3.3 percent rate over the next year. This remains on the high side of other forecasts, many of which are predicting reductions in real GDP.
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?”
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. But the yield curve can also be used 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 a low 1.11 percent, up a bit from December's 0.5 percent.
The probability of recession coming out of the yield curve is very low, and may seem strange the in the midst of the recent financial news, but one aspect of those concerns has been a flight to quality, which lowers Treasury yields. Furthermore, both the federal funds target rate and the discount rate have remained low, which tends to result in a steep yield curve. Remember also that the forecast is for where the economy will be next year, not where it is now.
Consider that, in the spring of 2007, the yield curve was predicting a 40 percent chance of a recession in 2008, something that looked out of step with other forecasters at the time.
To compare the 1.11 percent to some other probabilities, and learn more about different techniques of predicting recessions, head on over to the Econbrowser blog.
Of course, it might not be advisable to take this number quite so literally, for two reasons. (Not even counting Paul Krugman's concerns.) 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.