Unexpectedly Intriguing!
November 27, 2006

In the latest edition of the Federal Reserve Board of San Francisco's letter, economists John Fernald and Bharat Trehan ask the our headline question for the day (via Greg Mankiw). Unlike the most avid recession hounds, they've been using the method developed by Jonathan Wright, for which we've dedicated a tool here at Political Calculations!

Here's the key graph from the SF Fed letter, which tracks the recent history of the probability of recession from 1964 through November 8, 2006:

It certainly appears that the risk of recession is rising, so it seems like a good idea to update the SF Fed's calculations with the latest numbers. Now, to use Wright's method, you need to average a quarter's worth of data for the spread between the 3-month and 10-year Constant Maturity Treasury yields, as well as for the Federal Funds Rate.

Going back over a one-quarter period, beginning August 23, 2006 and ending November 24, 2006, we find the following average data:

      10-Year = 4.70%
      3-Month = 5.02%
      Federal Funds Rate = 5.25%

Using our tool, this gives the current probability of a recession beginning in the U.S. sometime within the next 12 months to be 46.4%. Looking at this data over the past several weeks, the probability of recession is trending higher.

Regular users of our tool know that we point to Yahoo's composite bond rates for the Treasury data. These yields are discounted from the Constant Maturity series and so far, we've found them to be a fairly good substitute for the data averaged over a quarter, which isn't directly available on the web.

Using this daily data, we find the probability of recession beginning in the next 12 months to be 47.4%, which we obtained using the discounted daily treasury rates for the 10-Year = 4.54% and the 3-Month = 4.89% with the same Federal Funds Rate for November 24, 2006.

Finally, if we use the closing bell data for the Constant Maturity Treasuries for November 24, 2006, the tool returns a recession probability figure of 51.6%. As with any single data point, this may be a spike, it may be random noise, or it may be a real trend. That's why Wright uses the data averaged over a one quarter period of time. In any case, it provides a point of comparison for Fernald's and Trehan's November 8 data point in the table above, which appears to be slightly under the 50% mark.

We'll go more into this topic in the days ahead, but for now, we're not prepared to make the call for an imminent recession, as the conditions we've previously noted as being essential in making the call have yet to occur.

Fernand and Trehan conclude the SF Fed's letter by noting that:

... not only are recessions hard to predict, it is even hard to tell that the economy is in a recession once it has begun.

Well, for that, we would rely on the recession probability index developed by James Hamilton and Marcelle Chauvet, which would provide the earliest, best indication that the U.S. economy has entered into recession.

About Political Calculations

Welcome to the blogosphere's toolchest! Here, unlike other blogs dedicated to analyzing current events, we create easy-to-use, simple tools to do the math related to them so you can get in on the action too! If you would like to learn more about these tools, or if you would like to contribute ideas to develop for this blog, please e-mail us at:

ironman at politicalcalculations.com

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