Jonathan Wright, a brilliant research economist at the Federal Reserve Board, recently completed a very interesting paper titled The Yield Curve and Predicting Recessions. Wright’s research seems to have been influential in Fed Chair Ben Bernanke’s recent assessment that the current very flat yield curve does not signify a coming significant economic slowdown.
Wright used a probit model to describe the probability of an economic recession sometime during the next four quarters as a function of the spread between the yields on 10-year and 3-month U.S. Treasury securities. Unlike some other researchers, Wright found little evidence that the relation has been unstable over time, though he acknowledged that, given the relatively low number of recessions we have observed, it might be difficult to detect any changes that might have occurred.
Wright’s base model (which he called “Model A”) describes the probability of a recession sometime within the next year as a function of S, the spread between the 10-year and 3-month bond yield,
where F denotes the cumulative distribution function for a standard Normal variable with mean zero and unit variance. The probabilities implied by different values of S are summarized in the table on the left. According to this simple model, one might have started to become concerned last summer when the spread fell below 100 basis points. Note that with the spread now below 25 basis points, Wright’s Model A would judge that we are more likely than not to see a recession within the next year. The probabilities as calculated from this model at any historical date are compared with actual recessions in the figure below.
|Spread||FF = 3.5||FF = 4.0||FF = 4.5||FF = 5.0||FF = 5.5|
However, Wright and other researchers (such as Andrew Ang, Monika Piazzesi and Min Wei in a research paper that appeared in the most recent issue of the Journal of Econometrics) suggest that in addition to the spread it is helpful to look at the overall level of short term interest rates. Wright’s Model B uses both the spread (S) and the funds rate (R) to calculate the probability:
According to Model B, the low values for the spread that we saw last summer were not a source of concern for future economic activity because a fed funds rate below 4% was so low by historical standards. Research like this seems to have played a role in Fed Chair Ben Bernanke’s assessment that
I would not interpret the currently very flat yield curve as indicating a significant economic slowdown to come, for several reasons. First, in previous episodes when an inverted yield curve was followed by recession, the level of interest rates was quite high, consistent with considerable financial restraint. This time, both short- and long-term interest rates–in nominal and real terms–are relatively low by historical standards
Of course, one would expect that the real fed funds rate, rather than the nominal fed funds rate, is the variable that should matter for such calculations, though Wright did not find any statistical evidence that adding inflation helped improve the predictions generated by Model B. And although it is true that the level of the nominal fed funds rate remains low relative to the historical average, I don’t agree with Bernanke’s assessment that the short-term real interest rate is still low in comparison with the historical average.
Even so, if we accept Model B at face value, a couple more 25-basis point bumps by the Fed would put the funds rate at 5.25% and likely push the spread into negative territory. From the table above, that starts to make a recession look like a pretty good possibility.
Think Bernanke wants to take that gamble? I’m betting he won’t.
UPDATE: Political Calculations has created a neat tool that lets you input values for the different yields to calculate the probabilities from Wright’s Model B.