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Thursday, April 28, 2005

Interest Rate Spreads and Recessions

CNN Money points to the flattening of the yield curve:

The yields on the longer-term treasuries … have not seen much in the way of gains over the past year, even as shorter-term rates … steadily gained ground.

The condition is known as a flattened yield curve … it is a warning sign for the economy that economists take seriously.

History tell us that as the two types of interest rates get closer, slower economic activity is almost sure to occur. If short-term rates overtake longer-term rates, a recession is virtually always in the offing. The last time that happened was from July through November 2000.

There is some truth to this assertion. Here is a graph of the interest rate spread between 10 year notes and 3 month T-Bills as discussed in the article along with recessions (peak to trough) as identified by the NBER. The sample period is from April 1953 through March 2005:

 

(Click on graph for larger and clearer version)

It is not inevitable that a recession follows a negative spread, but there is an association. A good counter example is the mid 1960's where the spread was negative but no recession occurred. In the other direction the spread was positive (but near zero) prior to the 1990-91 recession.

The data in the graph are monthly and end in March 2005. The last value of the spread in the sample is 1.75. Data for 4/18/05 through 4/22/05 give spreads of 1.42, 1.36, 1.41, 1.5, 1.39. This is not yet in what appears to be the danger zone, recessions generally follow spreads that are between zero and one or negative in the graph, but the spread is certainly headed in that direction. Even though there are more sophisticated approaches to predicting the movement of output over time involving more variables than just the spread, as we wonder about the probability and timing of hard versus soft landings, this is a variable to watch.

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    Posted by on Thursday, April 28, 2005 at 01:08 PM in Economics, Inflation, Macroeconomics, Monetary Policy | Permalink  TrackBack (0)  Comments (0)

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