Political Calculations
April 10, 2006

How likely is it that there will be a recession in the next 12 months? Well, now you can find out for yourself with Political Calculations' latest tool, which does the math developed by the Federal Reserve Board's Jonathan Wright in The Yield Curve and Predicting Recessions (HT: James Hamilton's Econbrowser, where the specific formulation used in the following tool was outlined).

In the tool below, enter the current bond yields for the 10-Year Treasury Bond and the 3-Month Treasury Bond. You'll also need to enter the Federal Funds Rate. The tool will determine the probability of a recession occurring in the next 12 months from the spread between the treasury bonds and factoring in the Federal Funds Rate, according to Wright's Model B:

Update (22 September 2006): We've developed a tool for visualizing the odds that will help you quickly determine where we are in terms of recession risk!

Update (15 November 2006): We've provided some guidance on how to make the recession call!

Bond Yield and Federal Funds Rate Data
Input Data Values
10-Year Treasury Bond Yield (%)
3-Month Treasury Bond Yield (%)
Federal Funds Rate (%)


Probability of Recession in Next 12 Months
Calculated Results Values
Probability of Recession (%)

Using this model, a combination of two factors greatly increases the likelihood of a recession:

  1. An inverted yield curve (a negative spread produced when the 10-year treasury bond yield rate drops to be lower than the 3-month treasury's yield).
  2. A high federal funds rate.

How well will this method work in predicting future recessions? Time will tell, but for now, James Hamilton reports that it does appear to be a factor in setting the Fed's policy:

According to Model B, the low values for the spread that we saw last summer were not a source of concern for future economic activity because a fed funds rate below 4% was so low by historical standards. Research like this seems to have played a role in Fed Chair Ben Bernanke's assessment that

I would not interpret the currently very flat yield curve as indicating a significant economic slowdown to come, for several reasons. First, in previous episodes when an inverted yield curve was followed by recession, the level of interest rates was quite high, consistent with considerable financial restraint. This time, both short- and long-term interest rates--in nominal and real terms--are relatively low by historical standards.

As for James Hamilton's assessment of the Fed's recession predicting model:

... if we accept Model B at face value, a couple more 25-basis point bumps by the Fed would put the funds rate at 5.25% and likely push the spread into negative territory. From the table above, that starts to make a recession look like a pretty good possibility.

Think Bernanke wants to take that gamble? I'm betting he won't.

We here at Political Calculations are hoping (not betting) he won't.

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Political Calculations' Recession Probability Track shows the probability that the U.S. economy will be in recession 12 months from the indicated date (shown in red) while revealing the probability trend over the past four years.

Previously, the probability of recession peaked at 50% on 4 April 2007, which means that March-April 2008 was the most likely period in which the NBER would have found the U.S. to be in recession.

As it happens, they almost did. The NBER instead chose December 2007 as the beginning month of the most recent recession (we had found a 46% probability for a recession beginning in that month!)

On the Moneyed Midways

Political Calculations is also the online home of On the Moneyed Midways (aka OMM), a review of the best posts contributed to the week's best business and money-related blog carnivals. More than that, we also name one post in each edition as being The Best Post of the Week, Anywhere! and at the end of each year, we name The Best Post of the Year, Anywhere! as well as identifying the best blogs we found during the course of the year!

The link below will take you to the running index containing our most recent back issues (you can easily navigate the index to find older editions.)

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