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Yield Curve as a Predictor of U.S. Recessions (1)

Yield Curve as a Predictor of U.S. Recessions (1) - June...

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The Yield Curve as a Predictor of U.S. Recessions Arturo Estrella and Frederic S. Mishkin The yield curve—specifically, the spread between the interest rates on the ten-year Treasury note and the three-month Treasury bill—is a valuable forecasting tool. It is simple to use and significantly outperforms other financial and macroeconomic indicators in predicting recessions two to six quarters ahead. Economists often use complex mathematical models to forecast the path of the U.S. economy and the likelihood of recession. But simpler indicators such as interest rates, stock price indexes, and monetary aggregates also contain information about future economic activity. In this edition of Current Issues , we examine the useful- ness of one such indicator—the yield curve or, more specifically, the spread between the interest rates on the ten-year Treasury note and the three-month Treasury bill. To get a sense of the relative power of this variable, we compare it with other financial and macroeconomic variables used to predict economic events. Our analysis differs in two important respects from earlier studies of the predictive power of financial vari- ables. 1 First, we focus simply on the ability of these variables to forecast recessions rather than on their success in producing quantitative measures of future economic activity. We believe this is a useful approach because evidence of an oncoming recession is of clear interest to policymakers and market participants. Second, we choose to examine out-of-sample, rather than in-sample, performance—that is, we look at accu- racy in predictions for quarters beyond the period over which the model is estimated. This feature of our study is particularly important because out-of-sample perfor- mance provides a much truer test of an indicator’s real-world forecasting ability. Why Consider the Yield Curve? The steepness of the yield curve should be an excellent indicator of a possible future recession for several rea- sons. Current monetary policy has a significant influ- ence on the yield curve spread and hence on real activ- ity over the next several quarters. A rise in the short rate tends to flatten the yield curve as well as to slow real growth in the near term. This relationship, how- ever, is only one part of the explanation for the yield curve’s usefulness as a forecasting tool. 2 Expectations of future inflation and real interest rates contained in the yield curve spread also seem to play an important role in the prediction of economic activity. The yield curve spread variable examined here corresponds to a forward interest rate applicable from three months to ten years into the future. As explained in Mishkin (1990a, 1990b), this rate can be decomposed into expected real interest rate and expected inflation com- ponents, each of which may be helpful in forecasting.
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