Others have seen what is and asked why. I have seen what could be and asked why not..
–Pablo Picasso.
Abstract
This paper proposes a new framework that identifies a threshold between the fed funds rate and the 10-year Treasury yield and, when the threshold is breached, the risk of a recession in the near future is significant. Our framework predicted several recessions before the yield curve inversion point/monetary cycles’ approaches. In addition, our framework accurately forecasted peaks in the S&P 500 index.
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Notes
For more details about the effectiveness of the yield curve to predict recession see, Adrian et al. (2010).
Some analysts utilize the spread between the 10-year and 3-month Treasuries as a measure of yield curve. In our view, that spread is overly reliant on market expectations and less reflective of the monetary policy stance.
There are several potential reasons behind the inverted yield curve, and we discussed financial world’s expectations; for more details about the inverted yield curve, see, Adrian et al. (2010).
The yield curve approach missed the 1957–1958 recession completely. The monetary cycle method missed the recession by 2 months according to Adrian and Estella (2009), and was a complete miss, in a real-time analysis, by our reckoning.
The 1973–1975 and 1980 recessions are the only two periods when the Fed raised the fed funds rates during a recession.
In other words, we see this as an example of Goodhart’s Law at work: a correct policy response to an indicator could well superficially suggest that the indicator was in error.
References
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Iqbal, A., Bullard, S. & Silvia, J. Are yield-curve/monetary cycles’ approaches enough to predict recessions?. Bus Econ 54, 61–68 (2019). https://doi.org/10.1057/s11369-018-0100-6
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DOI: https://doi.org/10.1057/s11369-018-0100-6