Recessions are difficult to predict, in part because they occur rarely, but also because the factors that drive the economy into a recession most likely differ across episodes. As a consequence, a factor that may drive one recession may fare poorly in predicting other downturns. Using many explanatory variables to estimate the probability of recessions will likely result in a very limited ability to predict recessions outside the estimation sample. In contrast, the slope of the yield curve has proven a promising parsimonious indicator of downturns, possibly because a variety of factors, some of them complementary, can drive a yield curve inversion and at the same time carry information about a future recession.
The Relationship between the Yield Curve and Future Recessions
The slope of the yield curve is typically measured by the “term spread,” that is, by the difference between the yields on long- and short-term Treasury securities. A common measure of the term spread, and the one we focus on here, is the difference between the 10-year Treasury bond yield and the 3-month Treasury bill yield. A yield curve inversion occurs when the spread is negative—when the long-term yield is less than the short-term yield.
Several factors can drive a yield curve inversion. Most common is when the central bank temporarily increases the short-term interest rate and the long-term rate rises less than proportionately (because it embeds expectations that future short-term rates will eventually revert to lower levels). Thus as tighter policy works its way through the economy, the restrictive monetary policy stance can generate an inverted yield curve today and weaker activity in the future. This does not imply that monetary policy is necessarily the sole or primary cause for a recession. For example, forecasts from the Federal Reserve Board staff before the onset of the three most recent recessions, as dated by the National Bureau of Economic Research (NBER), show that actions taken to tighten the stance of monetary policy were intended to slow the economy to a more sustainable pace of growth, not to purposely tip the economy into a recession.4 This does not rule out that the Board staff could have misjudged the effect of policy tightening on economic activity, or the underlying resilience of the economy. It is also possible, however, that a policy action meant to slow the pace of growth to a more sustainable level was exacerbated by exogenous and unanticipated adverse factors. While this implies systematic bad luck striking precisely at the time of tight monetary policy, it is also true that slower growth makes the economy more vulnerable to adverse shocks, thus raising the likelihood of a recessionary event.
A yield curve inversion can also emerge due to a decline in longer-term interest rates. Investors’ expectations about future economic activity, and the associated expectations about future monetary policy, will drive movements at the longer end of the curve. For example, an anticipated slowdown in the pace of economic activity will put downward pressure on long-term yields, because they are driven by expectations of future short-term rates, and investors recognize that the central bank will have to lower rates eventually if the slowdown materializes. Such a decline in long-term yields can generate a yield curve inversion that is correlated with a future recession to the extent that investors correctly anticipate the downturn. Needless to say, theses dynamics could also occur in the context of the previously described monetary policy tightening scenario.
Changes in risk assessments of the future state of economic activity can also affect long-term rates and lead to an inverted yield curve. Indeed, long-term Treasury bonds are an effective hedge against states of the world with low economic activity, as (long-term) interest rates tend to be depressed when activity is low, and so bond prices appreciate when activity is depressed (recall that the price of a bond is inversely related to its yield). When risks of a future downturn increase, even with an unchanged modal path for the future course of monetary policy, there can be a “flight to quality” that bids up the price of long-term Treasury bonds and lowers their yield.5 Thus if a recession materializes, it will be correlated with the inverted yield curve.
In sum, many non-mutually exclusive channels could rationalize why the yield curve has predictive power for future economic activity. In particular, the yield curve aggregates information from a host of sources and captures investors’ expectations about the economy’s future prospects, which are driven by factors that can change over time. Importantly, the yield curve also incorporates information about the stance of monetary policy, which is tied to where the economy stands in the business cycle and could be informative about the likelihood of a future downturn. Relative to other financial market indicators, such as broad stock market indices, that the literature shows to have, at times, predictive power for future economic activity, the yield curve has the advantage of more readily providing additional information about investors’ perceptions of risks.
Evaluating the Yield Curve’s Predictive Power
It is certainly debatable whether the aforementioned reasons for the predictive power of the yield curve are compelling. After all, investors can be wrong about future economic developments, and monetary policy tightening that inverts the yield curve should not necessarily translate into an economic downturn. Indeed, the yield curve is frequently used to predict recessions in large part because it seems to work in practice. While the literature reaches different conclusions about which segment of the yield curve has the greatest predictive power (see Miller 2019), there is much less debate about the general usefulness of the yield curve as an indicator of future US recessions.6
There is much less consensus, however, on what role monetary policy plays in the yield curve’s predictive power. Wright (2006), for example, finds that the term spread, as a summary measure of the yield curve, owes its predictive power for future recessions, at least in part, to the stance of monetary policy. Bauer and Mertens (2018) argue the opposite—that the ability of the yield curve to predict recessions has little to do with the stance of monetary policy. These and other studies, however, do not gauge the stance of monetary policy vis-à-vis a time-varying neutral federal funds rate (neutral rate)—the rate that, absent any shocks, will keep the economy at equilibrium.7 Their implicit assumption of a constant neutral funds rate runs against evidence by Laubach and Williams (2003 and subsequent updates), which shows that the estimates of the neutral (or natural) short-term real rate of interest, while imprecise, tend to exhibit significant variation over time. Moreover, Fuhrer et al. (2018) document that the Federal Open Market Committee’s implicit inflation target, which affects estimates of the neutral rate, was also time-varying until 1996, when the FOMC implicitly adopted a 2 percent target; the committee explicitly adopted the 2 percent target in 2012.
In principle, changes to the real and inflation components of the neutral federal funds rate could offset each other and result in a constant (nominal) neutral rate. However, there is little reason to expect that this is the case in practice. In the next section we define our measure of the time-varying neutral rate and show how the predictive power of the yield curve for future recessions is affected by the relative stance of monetary policy measured in a way that takes into account time-variation in the real neutral rate and in the FOMC’s inflation target.
