Insight Line—October 8, 2007

The thing about economic recessions is that you don’t know you’re in one until it happens. You see if there is enough statistical evidence to suggest a recession is coming, chances are it is already here. That’s why Wall Street economists and market pundits regularly attempt to describe the onset of an economic contraction—defined by the official arbiter of such statistical measures, the National Bureau of Economic Research—as an increasingly probable event. In fact, some, as a recent spate of widely monitored headlines attests, go so far as to ascribe a certainty level, say 40 percent or some such number, to their prognostication.

Yet if the confirmation of a recession is indeed backward data dependent, how can economists’ pronouncements of today exhibit any confidence in assigning probabilities? Well, I believe the answer begins with the theoretical work presented over the course of the past 20-odd years by Federal Reserve Board Governor Frederic S. Mishkin in conjunction with Federal Reserve Bank of New York senior economist Arturo Estrella.

First appearing in June 1996, their landmark study titled, “The Yield Curve as a Predictor of U.S. Recessions,”¹ set out the theoretical framework for assigning probabilities to the onset of a recession based on the shape of the U.S. Treasury yield curve (the yield differential between the three-month Treasury bill and the 10-year Treasury note).

In the study, Estrella and Mishkin essentially suggest that the wisdom of the crowd—as reflected in the shape of the yield curve—was a better measure of an impending economic contraction than more readily accepted standards such as the Conference Board’s Leading Economic Indicators. However, at the time of its publication, this assertion received little acknowledgement beyond economic circles. After all, most investors considered the shape of the yield curve more of a technical indicator than predictive economic analysis. That is, until the recession of 2001 made its presence known.

While many Wall Street, government and private sector economists steadfastly denied the pending slowdown, the shape of the yield curve—at least according to the authors—foretold of the coming economic contraction as early as August 2000. At that time, the shape of the curve briefly moved beyond the 50-50 point (corresponding to a spread of -82 basis points) of a recession commencing sometime in the upcoming four quarters.

(The results of the model, based on data from the first quarter of 1960 to the first quarter of 1995, are presented in the accompanying table showing the values of the yield curve spread that correspond to estimated probabilities of a recession four quarters in the future.)

Estimated Recession Probabilities for Probit Model Using the Yield Curve Spread

Four Quarters Ahead
Recession Probability (percent)	Value of Spread (Percentage Points)
5	1.21
10	0.76
15	0.46
20	0.22
25	0.02
30	-0.17
40	-0.50
50	-0.82
60	-1.13
70	-1.46
80	-1.85
90	-2.40
Note: They yield curve spread is defined as the spread between the interest rates on the ten-year Treasury note and the three-month Treasury bill.

Needless to say, the model’s probabilistic framework proved correct, and academics and investors alike took notice.

As the economy emerged from recession in late 2001, so too had newly minted academic work citing the Estrella-Mishkin analysis as key to understanding the potential dynamics of an evolving economy. Simply put, the die had been cast. Forecasting recessions—arguably an exercise fraught with uncertainty—is now a statement of probabilities suitable for evaluation within investors’ longer-term forecasts.

Of course, as authoritative as such forecasts sound, none of this assures a certainty of knowledge into the nuances of the business cycle. Then again, given that the policy actions of the FOMC influence the shape of the yield curve, it seems to me, as with many games of chance, the house—i.e., the FOMC—not Wall Street is the one setting the odds.

¹ Estrella, Arturo and Frederic S. Mishkin, “The Yield Curve as a Predictor of U.S. Recessions,” Current Issues in Economics and Finance, Volume 2 Number 7, The Federal Reserve Bank of New York, New York, New York, June 1996,.