Using the Yield Curve to Make Real Time Forecasts

From the NY Fed, guidelines on using the yield curve to predict future economic activity. Here's part of the introduction and a link to the paper:

The Yield Curve as a Leading Indicator: Some Practical Issues , by Arturo Estrella and Mary R. Trubin, NY Fed: Since the 1980s, economists have argued that the slope of the yield curve—the spread between long- and short-term interest rates—is a good predictor of future economic activity. While much of the existing research has documented how consistently movements in the curve have signaled past recessions, considerably less attention has been paid to the use of the yield curve as a forecasting tool in real time. This analysis seeks to fill that gap by offering practical guidelines on how best to construct the yield curve indicator and to interpret the measure in real time. ...

Since the 1980s, an extensive literature has developed in support of the yield curve as a reliable predictor of recessions and future economic activity more generally. Indeed, studies have linked the slope of the yield curve to subsequent changes in GDP, consumption, industrial production, and investment.

Whereas most earlier analysis has focused on documenting historical relationships, the use of the yield curve as a forecasting device in real time raises a number of practical issues that have not been clearly settled in the scholarly literature. First, the lack of a single accepted explanation for the relationship between the yield curve and recessions has led some observers to question whether the yield curve can function practically as a leading indicator. If economists cannot agree on why the relationship exists, confidence in this indicator may be weakened. Second, the literature lacks a standard approach to constructing forecasts based on movements in the yield curve. How should the slope of the yield curve be defined? What measure of economic activity should be used to assess the yield curve's predictive power? The current variety of approaches to producing and interpreting yield curve forecasts may lead to misreadings of the signal in real time.

This edition of Current Issues undertakes to shed light on some of the practical problems arising from the use of the yield curve as a forecasting tool. We begin by considering whether there are explanations of the yield curve's predictive power that would justify the operational use of this signal. We then discuss how best to construct the yield curve indicator and subsequently interpret the measure in real time. Our analysis offers specific guidelines on the choice of interest rates used to calculate the spread, the definition of recessions used in the forecasts, and the strength and duration required of the yield curve signals. [...continue reading...]