Handicapping the Next Recession

Before you buy that plasma TV for the family room or splurge on an 80-gig iPod for your office "secret Santa" party, it might be nice to know if the economy is about to tank (And nothing like today's triple-digit drop in the Dow to give one the shakes.) No surprise; forecasting such downturns is tough.

"Difficult to predict" is how a new study from the Federal Reserve Bank of San Francisco terms recessions. Indeed, study authors John Fernald and Bharat Trehan point out how the well-known Blue Chip survey of economists recently responded when asked the odds of a recession in the next 12 months. The consensus was that there was a 24.8 percent chance. The average of the highest 10 responses was 36.5 percent, and the average of the lowest 10 was 14.8 percent. (The consensus was 25.1 percent in September and 26.9 percent in August.)

But those numbers should give little solace. Fernald and Trehan also note that the optimistic numbers are about the same as those recorded right before the March 2001 recession. And even once that downturn was underway, 93 percent of respondents failed to realize that a recession had begun. The most popular tool for predicting recessions is the yield curve. An inverted yield curve–when long-term bond yields fall below short-term yields–is often thought to signal tough economic times ahead. Right now, the yield curve is forecasting a 50-50 chance of a recession.

But many forecasters have been skeptical of the inverted yield curve. As Oak Associates economist Edward Yardeni writes in a note today, "In the past, an inverted yield curve was associated with a credit crunch, which obviously led to recessions. This time, for the first time ever, the yield curve is associated with a global glut of saving. All that liquidity has pushed the 10-year bond yield below the federal funds rate and is one of the reasons why stock prices are soaring."

To cover all the bases, Fernald and Trehan reviewed just about every survey, indicator, and model that they could find. And their estimates of "the probability of recession . . . are all lower than the one based on the . . . yield curve." Not to mention that stock and bond investors don't seem to be worried, the authors find. "The Dow has hit record highs recently, and various risk spreads (such as the rate on corporate bonds relative to treasuries) remain at low levels. Taken together with our inability to explain the unusually low level of long-term rates, this suggests to us that while the probability of recession might have gone up somewhat in recent months, it is not yet at worrisome levels."