What Recession

In a 1996 paper entitled The Yield Curve as a Predictor of U.S. Recessions by Estrella and Mishkin from the NY Fed the authors analyzed various recessions and concluded that Recessions occur when the spread between the 10 year and 3 month Treasuries reached certain levels.

The authors state:

"The steepness of the yield curve should be an excellent indicator of a possible future recession for several reasons. Current monetary policy has a significant influence on the yield curve spread and hence on real activity 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, however, is only one part of the explanation for the yield curve’s usefulness as a forecasting tool. 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 authors continue:

" To assess how well each indicator variable predicts recessions, we use the so-called probit model, which, in our application, directly relates the probability of being in a recession to a specific explanatory variable such as the yield curve spread.4 For example, one of the most successful models in our study estimates the probability of recession four quarters in the future as a function of the current value of the yield curve spread between the ten-year Treasury note and the three-month Treasury bill. The results of the model, based on data from the first quarter of 1960 to the first quarter of 1995, are presented in a table showing the values of the yield curve spread that correspond to estimated probabilities of a recession four quarters in the future."

We show the table below:

Recession Probability (%)	Value of Spread (10 Year - 3 Month in %)
5	1.21
10	0.76
15	0.46
20	0.22
25	0.02
30	-0.17
40	-0.5
50	-0.82
60	-1.13
70	-1.46
80	-1.85
90	-2.4

Now we update the information by first plotting the spread from January 1982 to the present as shown below:



















Then we applied the probability curve of the authors to obtain the following:



















And we see we have no recession at this time. The yield curve is strongly upward and it shows if one believes the analysis that a recession does not exist!

The authors' conclusions are:

"First, forecasting with the yield curve has the distinct advantage of being quick and simple. With a glance at the ten-year note and three-month bill rates on the computer screen, anyone can compute a probability forecast of recession almost instantaneously by using a table such as ours.

Second, a simple financial indicator such as the yield curve can be used to double-check both econometric and judgmental predictions by flagging a problem that might otherwise have gone unidentified. For example, if forecasts from an econometric model and the yield curve agree, confidence in the model’s results can be enhanced. In contrast, if the yield curve indicator gives a different signal, it may be worthwhile to review the assumptions and relationships that led to the prediction.

Third, using the yield curve to forecast within the framework outlined here produces a probability of future recession, a probability that is of interest in its own right."

If the authors are correct we should not have an recession at this time, yet we do. Why? The yield curve is artificially held down by the FED, they have pegged the short term rate via the discount rate. This is driving down the curve and perhaps not allowing for a "natural" flow of funds.

One is reminded of the Mises School view of the Depression, a view which holds the banks as solely responsible. Then there is the Temin retort, the Keynes School answer, requiring more Government spending. This debate continue even in the small corner of debate.