Fed Paper Looks at Yield Curve-Recession Connection

The ability to predict a recession is a skill that seems to elude most forecasters, but a new working paper from the San Francisco Federal Reserve suggests the yield curve may be a reliable indicator that many overlook.Glenn D. Rudebusch and John C. Williams of the San Francisco Fed write in a paper entitled “Forecasting Recessions: The Puzzle of the Enduring Power of the Yield Curve” that “the yield curve, specifically the spread between long- and short-term interest rates, does contain useful information at that forecast horizon for predicting aggregate economic activity and, especially, for signaling future recessions.” Although ignored by most forecasters, a vocal minority places a lot of emphasis on an inverted yield curve as a predictor of recession. The inverted yield curve is an unusual occurrence in which short-term interest rates are higher than long-term rates. The study used the average spread between the yield on a 10-year U.S. Treasury note and the 3-month Treasury bill over the course of a quarter.


The authors offer some possible reasons why forecasters may not use the yield curve to predict recessions. They suggest economists may dismiss the yield curve because of it is unclear why it would predict recessions, and although it has worked in the past since its relationship isn’t understood it may not work in the future. “This paper, however, shows that the relative predictive power of the yield curve does not appear to have diminished much, if at all [in some 20 years],” the authors said.

The conclusions are at odds with the views of Fed Chairman Ben Bernanke, who believes the yield curve isn’t as good a recession predictor as it once was. “I would not interpret the currently very flat yield curve as indicating a significant economic slowdown to come,” he said early last year. In the past, when the yield curve was inverted, short-term rates were “quite high,” but now, they aren’t. Second, the flattening could result from a structural fall in the “term premium,” that is the additional return investors require for holding long as opposed to short-term debt securities
The reason why the inverted yield curve is a good predictor of recessions is because it indicates that the market is being manipulated. If the interest rates in our country were not controlled by a central bank then an inverted yield curve would probably never happen. The federal reserve artificially inflates the money supply, this makes it easier for institutions to make long term loans to, for example, home buyers. Eventually their standards for lending become very low and vehicles such as interest only mortgatges become popular because the bankers are trying to lock in long term returns and they need to compete with each other. Long term rates eventually go down a lot because of this competition. Asset prices rise, risk tolerance goes up, prices keep rising, Fed realizes they put to much money into the system (INFLATION) and they raise the interest rates. Money becomes more scarce, asset prices fall and hence a “recession” happens. The people being hurt by what is happening now took credit they could not afford unless asset prices rose. The government should let nature take its course and let the bankers who were irresponsible pay for their hubris