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January 2014 (December 11, 2013-January 20, 2013) In This Issue: Banking and Financial Markets Labor Markets, Unemployment, and Wages Tracking Recent Levels of Financial Stress Employee Compensation Costs during the Recovery Households and Consumers Household Financial Conditions Monetary Policy Inflation and Prices The Yield Curve and Predicted GDP Growth, December 2013 Expectations Stay Anchored in Spite of Declining Inflation Banking and Financial Markets Tracking Recent Levels of Financial Stress 01.17.14 by Amanda Janosko Cleveland Financial Stress Index Standard deviation 3 October FOMC meeting Grade 4 2 December FOMC meeting 1 Grade 3 Government shutdown 0 Grade 2 -1 -2 Grade 1 -3 10/01/13 10/22/13 11/12/13 12/03/13 12/24/13 01/14/14 Source: Oet, Bianco, Gramlich, and Ong, 2012. "A Lens for Supervising the Financial System," Federal Reserve Bank of Cleveland working paper no. 1237. Stress-Level Contributions of Component Markets to CFSI 60 50 40 Credit Funding Equity Foreign exchange Real estate Securitization 20 10 10/21/13 11/10/13 11/30/13 12/20/13 In addition to measuring the overall level of stress in the financial system, the CFSI can also tell us about the relative contributions of six different financial markets to overall systemic stress. Again, looking over the fourth quarter of 2013 and into the first quarter of 2014, we can see that all of the markets—credit, equity, funding, foreign exchange, securitization, and real estate—contributed to the reduction in stress. The equity and securitization markets experienced the most significant reductions in their contributions to stress, while the foreign exchange, credit, real estate, and funding markets experienced more moderate reductions. The joint reduction in stress in all six financial markets led to a new historical low for the index on January 9, 2014. Previously, the lowest index reading had occurred in February 1997. CFSI 30 0 10/01/13 The Cleveland Financial Stress Index (CFSI) has trended down throughout the fourth quarter of 2013 and early this year, indicating a reduction in the level of stress in the US financial system. During the federal government shutdown in October 2013, the CFSI was in Grade 2 or a “normal stress” period, but as the year progressed the index moved into Grade 1, indicating a “low stress” period. As of January 14, the index stood at −1.833, substantially below the CFSI’s historic high reading of 3.094 on December 29, 2008 and slightly above the CFSI’s historic low of −2.023 on January 9, 2014. 01/09/14 Note: These contributions refer to levels of stress, where a value of 0 indicates the least possible stress and a value of 100 indicates the most possible stress. The sum of these contributions is the level of the CFSI, but this differs from the actual CFSI, which is computed as the standardized distance from the mean, or the z-score. Source: Oet, Bianco, Gramlich, and Ong, 2012. "A Lens for Supervising the Financial System," Federal Reserve Bank of Cleveland working paper no. 1237. Federal Reserve Bank of Cleveland, Economic Trends | January 2014 We can dive another level down into the factors contributing to stress by looking at the components that we track in each of these six financial markets. Stock market crashes, the only component in the equity market, reduced its contribution to stress by 85.2 percent during the fourth quarter of 2013. In the securitization market, the reduction in the residential-mortgage-backed-security spread drove the market’s overall reduced contribution to stress. Other notable components that helped drive the reduction in system stress include weighted dollar 2 Recent Highs and Lows of the CFSI Standard deviation 4 12/29/2008, 3.093 3 2 1 crashes, the commercial real estate spread, and the residential real estate spread. Note that the components responsible for the decline in overall stress share two characteristics; they contributed a large share to stress in the last quarter and their contribution has fallen significantly since. Some components, like the ABS spread, by contrast, show large percent change over the previous quarter but their contribution was very small to begin with. 0 -1 -2 2/18/1997, -1.850 1/9/2014, -2.054 -3 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 The Cleveland Financial Stress Index and all of its accompanying data are posted to the Federal Reserve Bank of Cleveland’s website at 3 p.m. daily. The data can be accessed at http://www.clevelandfed.org/research/data/financial_stress_index/. For a brief overview of how the index is constructed, visit http://www.clevelandfed.org/research/data/financial_stress_index/ about.cfm. Source: Oet, Bianco, Gramlich, and Ong, 2012. "A Lens for Supervising the Financial System," Federal Reserve Bank of Cleveland working paper no. 1237. Factors Contributing to Financial Market Stress Market Component Contribution to stress, 10/1/13 Contribution to stress, 12/31/13 Percent Equity Stock market crashes 10.613 1.567 −85.2 Securitization Real estate Foreign exchange Funding Credit Commercial MBS spread 0.545 0.551 1.1 Residential MBS spread 7.795 2.490 −68.1 ABS spread 0.593 0.051 91.4 Commerical real estate spread 1.637 0.838 −48.8 Residential real estate spread 2.641 1.971 −25.4 Weighted dollar crashes 6.914 5.208 −24.7 FInancial beta 0.602 0.352 −41.6 Bank bond spread 1.527 1.475 −3.4 Interbank liquidity spread 0.497 0.164 −67.1 Interbank cost of borrowing 0.139 0.125 −9.8 Covered interest spread 0.525 0.272 −48.2 Corporate bond spread 2.950 2.152 −27.0 Liquidity spread 3.536 3.183 −10.0 Commerical paper T-bill spread 0.424 0.130 −69.4 Treasury yield curve spread 1.001 0.987 −1.4 Note: “Contributions to stress” refers to levels of stress, where a value of 0 indicates the least possible stress and a value of 100 indicates the most possible stress. The sum of these contributions is the level of the CFSI, but this differs from the actual CFSI, which is computed as the standardized distance from the mean, or the z-score. Federal Reserve Bank of Cleveland, Economic Trends | January 2014 3 Households and Consumers Household Financial Conditions 01.08.14 O.Emre Ergungor and Daniel Kolliner Household Financial Balance Sheet Billions of dollars 110000 95000 Household assets 80000 65000 50000 Household net worth 35000 Household liabilities 20000 5000 2000 2002 2004 2006 2008 2010 2012 Note: Shaded bars indicate recessions. Source: Board of Governors of the Federal Reserve System. Household Assets Growth Four-quarter percent change During the Great Recession, household wealth fell nearly 20 percent. Due to the sluggish growth of the economy, it took five years for households to recover the lost ground. Since 2011, the growth of household assets and net worth has been on a strong upward trend. Should we worry about this trend, given that the Great Recession was preceded by a similar boom in household assets? We don’t think so. Unlike the pre-recession period, the current growth in assets is not carried on the shoulders of overextended consumers who are racking up substantial debt. Household liabilities have essentially been flat for almost two years. In previous recessions, Americans’ homes typically retained their value, but during the Great Recession, the housing market was hit hard. From 2007 all the way to 2011, nonfinancial assets—basically housing—have been a drag on household wealth. Only in recent quarters did home values once again become the stalwart supporter of household balance sheets. Thus, the asset growth we observed in the previous chart has been primarily driven by the growth in financial assets. 30 Nonfinancial assets 20 10 0 Financial assets -10 -20 -30 2000 2002 2004 2006 2008 2010 2012 Note: Shaded bars indicate recessions. Source: Board of Governors of the Federal Reserve System. Federal Reserve Bank of Cleveland, Economic Trends | January 2014 With the hard lessons of the Great Recession still fresh in our collective memory, households have been slow to take up new debt in the last two years, and lenders have been slow to extend revolving consumer credit, which primarily consists of credit card debt. Revolving consumer credit balances plummeted in 2008 and are currently barely higher than their level in the third quarter of 2012. Outstanding home mortgage debt is still contracting due to record write-offs and reduced demand for homes in previous years. Nonrevolving consumer credit, which consists of secured and unsecured credit for student loans, automobiles, durable goods, and other purposes, is the only credit category that shows some sign of life. It is currently 8.5 percent above year-ago levels. Note, however, 4 that the student loan component is entirely driven by federal government loans to students and does not reflect private market activity. Outstanding Debt On a more positive note, declining credit balances and historically low interest rates have cleared household balance sheets of their dangerous levels of debt from the pre-crisis period. The financial obligation ratio, which expresses household liabilities, such as credit card payments, mortgage payments, home property taxes, and rent payments, as a percentage of disposable income, is at its lowest level since the third quarter of 1981. Four-quarter percent change 20 Nonrevolving consumer credit Mortgage debt 15 10 5 The cautious behavior of American households is also manifesting itself in the savings rate. Before the downturn, in July 2005, the personal savings rate reached a record low of just 2.0 percent. Since then, the rate has steadily increased, peaking at 8.7 percent in 2012 due to high dividend and accelerated bonus payments before the rise in personal tax rates. Since that peak, households have maintained their savings rate above 4 percent, roughly where it was in 2004. Revolving consumer credit 0 -5 -10 2000 2002 2004 2006 2008 2010 2012 Note: Shaded bars indicate recessions. Source: Board of Governors of the Federal Reserve System. Personal Savings Rate Household Debt Service Percent Percent of disposable income 20 19 Financial obligation ratio 18 18 10 16 8 14 6 12 4 10 2 8 0 2000 17 16 Debt service ratio 15 14 2000 2002 2004 2006 2008 2010 2012 Note: Shaded bars indicate recessions. Source: Board of Governors of the Federal Reserve System. Federal Reserve Bank of Cleveland, Economic Trends | January 2014 2002 2004 2006 2008 2010 2012 Note: Shaded bars indicate recessions. Source: Bureau of Economic Analysis. 5 Parallel to their savings behavior, households have been circumspect in their spending, too. Consumption growth, up 3 percent since last year, indicates little appetite for spending. This is perhaps to be expected given that measures of consumer confidence and sentiment remain at the lowest levels of the 2001 recession (though they have recovered from their lows of the Great Recession). As confidence continues to improve, consumption growth should pick up pace. Consumption Four-quarter percent change 10 8 6 4 2 Consumption Retail sales 0 -2 -4 Indexes of consumer sentiment and confidence have gained traction since early 2009, likely due in part to recent small payroll gains, stabilizing (though still depressed) home sales, and stock market performance this past year. But consumers still seem to be proceeding with caution. -6 -8 -10 -12 2000 2002 2004 2006 2008 2010 2012 Note: Shaded bars indicate recessions. Sources: Bureau of Economic Analysis; Bureau of the Census. Consumer Attitudes Index, 1966 = 100 Index, 1985 =100 160 140 120 Consumer Sentiment (University of Michigan) 100 120 100 80 80 60 Consumer Confidence (Conference Board) 60 40 20 2000 40 2002 2004 2006 2008 2010 2012 Note: Shaded bars indicate recessions. Sources: Bureau of Economic Analysis; University of Michigan. Federal Reserve Bank of Cleveland, Economic Trends | January 2014 6 Inflation and Prices Expectations Stay Anchored in Spite of Declining Inflation 01.20.14 by Charles T. Carlstrom and Margaret Jacobson The Federal Open Market Committee (FOMC) has stated that its long-run target for inflation is 2 percent. Inflation does and will always vary around that target, but some observers are worried that the recent decline we have seen in inflation is especially troublesome because the federal funds rate is essentially zero. Inflation Expectations Percent 2.7 The worry is that with what is basically the economy’s short-term interest rate at zero, declines in inflation will cause one-for-one increases in the real interest rate (the after-inflation cost of borrowing). As a result, a decrease in economic activity could push down prices, and real economic activity could suffer because of the increase in real interest rates. 2.5 Ten-years ahead 2.3 2.1 One-year ahead 1.9 1.7 1.5 2012:Q1 2012:Q3 2013:Q1 2013:Q3 Source: Federal Reserve Bank of Philadelphia. PCE Inflation Quarterly, annualized percentage change 5.0 4.0 PCE price index 3.0 2.0 1.0 Core PCE price index 0.0 -1.0 3/2010 9/2010 3/2011 9/2011 3/2012 9/2012 3/2013 9/2013 Note: dashed lines for 2013:Q4 represent the average annualized percentage change for the months of October and November. Source: Bureau of Economic Analysis. Federal Reserve Bank of Cleveland, Economic Trends | January 2014 Though we have only limited information to go on, the decline in inflation is not likely to continue. While short-term inflation expectations have declined somewhat with the recent declines in inflation, longer-term inflation expectations have not drifted down to any meaningful extent, which should help mute ongoing declines in inflation. Personal Consumption Expenditures (PCE) inflation was essentially zero in the fourth quarter of 2013, significantly under the FOMC’s target. Throughout 2013, PCE inflation averaged about 1.0 percent, still below the 2 percent target. Meanwhile, core PCE inflation, which excludes the volatile energy and food components, averaged 1.1 percent for the first two months of the fourth quarter and over 2013 as well. While the FOMC is concerned about PCE inflation as a gauge of price stability, core PCE inflation is closely watched because there is some evidence that it predicts inflation over longer horizons better than total inflation. Although the FOMC focuses on the PCE, the Consumer Price Index provides another useful measure of inflation. The CPI is constructed from the prices faced by the average consumer, and CPI inflation typically runs about 25 basis points higher than PCE inflation. The overall pattern in recent 7 CPI Inflation Quarterly, annualized percentage change 5.0 CPI price index 4.0 3.0 2.0 1.0 CPI core price index 0.0 -1.0 3/2010 9/2010 3/2011 9/2011 3/2012 9/2012 3/2013 9/2013 Source: Bureau of Labor Statistics. PCE Inflation: Core Goods and Services Quarterly, annualized percentage change CPI inflation is quite similar to PCE inflation. CPI inflation in the fourth quarter was 0.9 percent, and core CPI inflation was approximately 1.6 percent. This is also what core CPI inflation averaged over the past year, though in the previous two years it averaged between 1.9 percent and 2.2 percent. Therefore, it too has shown a continual decline over the past two years. An interesting feature of both PCE and CPI inflation is the difference between the behaviors of inflation for service prices and goods prices. While the FOMC’s objective is for total inflation, some people are particularly concerned about the dramatic decline in goods prices. For example, PCE core-goods-price inflation has been falling steadily, dropping from 1 percent in 2011 to −0.7 percent in 2013, while inflation in core PCE service prices has been almost perfectly flat for three years, hovering around 2 percent. 4.0 3.0 PCE Core Services 2.0 1.0 PCE Core Goods 0.0 -1.0 -2.0 -3.0 -4.0 3/2010 9/2010 3/2011 9/2011 3/2012 9/2012 3/2013 9/2013 Note: dashed lines for 2013:Q4 represent the average annualized percentage change for the months of October and November. Source: Bureau of Economic Analysis. CPI Inflation: Core Commodities and Services We see the same pattern with the CPI. Core service inflation has been nearly steady for two years at a tad above 2 percent. But over that time, core goods inflation fell sharply, dropping from an increase of 2.2 percent in 2011 to a decrease of 0.1 percent in 2013. The decline in core goods inflation would be troublesome if core goods inflation predicted future inflation better than either core service or total core inflation. But arguably this is not the case. PCE service inflation is a better predictor of future inflation than goods inflation, while the evidence is mixed for the CPI. In the end, core (total) inflation is as good a predictor of both PCE or CPI inflation as goods or services inflation. Quarterly, annualized percentage change 4.0 Core CPI services 3.0 2.0 1.0 0.0 -1.0 Core CPI commodities -2.0 3/2010 9/2010 3/2011 9/2011 3/2012 9/2012 3/2013 9/2013 Another way of gauging whether or not the recent declines in inflation are a problem is to look at the long-term inflation outlooks of Blue Chip forecasters. Although their forecasts for near-term inflation have fallen a bit, the decrease seems to be transitory. While their prediction for inflation in the first quarter of 2014 is now ½ percentage point lower than they predicted in October, their forecasts for the second quarter of 2014 and onward have largely stayed the same. Source: Bureau of Labor Statistics. Federal Reserve Bank of Cleveland, Economic Trends | January 2014 8 Highlights Predictor PCE Predictor CPI One quarter ahead Four quarters ahead One quarter ahead Four quarters ahead Core PCE 0.81 0.65 Core CPI 0.73 0.55 Core PCE goods 0.74 0.57 Core CPI commodities 0.69 0.53 Core PCE services 0.78 0.65 Core CPI services 0.68 0.52 Note: Correlations are calculated from 1967:Q2 to 2013:Q3. Souces: Bureau of Labor Statistics, authors’ calculations. Longer-term inflation forecasts, as measured through TIPS (Treasury inflation-protected securities), were basically unaffected by the FOMC’s (surprising) December decision to taper asset purchases. Both 5- and 10-year forecasted rates show an insignificant decrease of around 2 basis points. Blue Chip CPI Projections Quarterly, annualized percent change 3.0 Forecast 2.5 While there is uncertainty about short-term inflation, every indication is that longer-term inflation expectations remain anchored around 2 percent. Blue Chip October CPI 2.0 Blue Chip December 1.5 1.0 2012:Q1 2012:Q4 2013:Q3 2014:Q2 2015:Q3 Source: Bureau of Labor Statistics/Blue Chip Newsletters. Five- and Ten-Year Breakeven Inflation Five- and Ten-Year Breakeven Inflation, December 18, 2013 Percent 5.0 Percent 2.3 2.2 Ten-year 4.0 Statement/projections 3.0 2.1 Press conference start Press conference end 2.0 2.0 1.9 1.8 Ten-year 1.0 Five-year Five-year 0.0 1.7 1.6 9:00 10:00 11:00 12:00 1:00 2:00 3:00 4:00 Source: Bloomberg. Federal Reserve Bank of Cleveland, Economic Trends | January 2014 5:00 -1.0 3/2010 3/2011 3/2012 3/2013 Source: Bloomberg. 9 Labor Markets, Unemployment, and Wages Employee Compensation Costs during the Recovery 01.10.14 by Joel Elvery The Federal Reserve’s two mandates—to keep inflation under control and to promote employment growth—overlap when it comes to employee compensation. Inflation typically leads to increases in nominal compensation, and firms increase prices in response, creating a feedback loop that pushes inflation higher. Compensation also rises when labor markets are strong and firms have to compete for workers, and it falls when labor markets are weak. So when compensation costs are rising, it can indicate greater risk of inflation and strengthening labor markets. When they’re falling, it can indicate the reverse. Which has it been lately? Share of Average Compensation Costs 9.8% 7.8% 4.8% 8.5% Wages and salaries Health insurance Retirement and savings Legally required benefits Other 69.1% Sources: Bureau of Labor Statistics’ Employer Costs for Employee Compensation: September 2013. The Bureau of Labor Statistics’ quarterly Employer Costs for Employee Compensation provides detail on the components of average hourly compensation. As shown in the chart below, in the third quarter of 2013 wages and salaries were 69.1 percent of compensation costs. The other major parts of compensation are health insurance (8.5 percent), legally required benefits (which includes unemployment insurance and the employer’s share of payroll taxes) (7.8 percent), and retirement and savings benefits (4.8 percent). Though we most often use salary earnings as a proxy for compensation, earnings and compensation can have different trends since earnings make up only about two-thirds of compensation. For example, from the first quarter of 2004 to the third quarter of 2007, average real hourly wages declined 0.8 percent, while average real hourly total compensation rose 0.9 percent. All components of compensation costs dramatically shifted up during the most recent recession. This shift is most likely due to the fact that these measures are average hourly costs for employed workers. Less-skilled workers are more likely to lose their job in a recession than high-skilled workers, so the skill and compensation levels of the workers who remain employed during a recession are higher. While real average hourly wages and salaries fell 3 percent from the first quarter of 2004 to the third Federal Reserve Bank of Cleveland, Economic Trends | January 2014 10 Real Average Hourly Compensation Costs Index (2004:Q1 = 100) Index, 2004:Q1 = 100 120 Health insurance 115 Retirement and savings 110 105 Total compensation 100 Wage and salary 95 90 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Source: Author’s calculations from the Bureau of Labor Statistics’ Employer Costs for Employee Compensation: March 2004 through September 2013. Change in Real Average Hourly Compensation Costs Annualized percent change 3.5 3.0 Pre-recession Recovery 2.5 2.0 1.5 1.0 0.5 0.0 -0.5 -1.0 -1.5 -2.0 Total Wage and Health Retirement Legally compensation salary insurance and savings required benefits Other Source: Author’s calculations from the Bureau of Labor Statistics’ Employer Costs for Employee Compensation: March 2004 through September 2013. Federal Reserve Bank of Cleveland, Economic Trends | January 2014 quarter of 2013, both health insurance and retirement and savings markedly increased (17 percent and 20 percent, respectively). As a result, total average hourly compensation was effectively the same in the two periods. We divide the data into pre-recession (2004:Q1 to 2007:Q3) and recovery (2009:Q2 to 2013:Q3) subsets and omit the recession due to the sudden change in who is employed. When we do this, we see that while total compensation rose 0.2 percent per year before the recession, it has declined 0.5 percent per year since the recovery began. Meanwhile, wage and salary compensation fell 0.2 percent per year before the recession and 0.8 percent per year since the recovery began. Legally required benefits and wages and salaries follow similar trends during the two periods, which is unsurprising since most components of legally required benefits are based on wages and salaries. Health insurance and retirement and savings benefits grew in both periods, but the rate of growth was much higher before the recession (4.4 times as high for health insurance and 2.3 times for retirement and savings). Other compensation grew about 1 percent per year before the recession, and it has declined about 1 percent per year since the recovery began. What explains the decline in average compensation during the recovery? As the economy recovers, lessskilled workers find work again and average hourly compensation falls. Also, the higher-than-normal unemployment rate means employers do not need to increase compensation to fill openings. The decline in average compensation may also reflect the shift to more part-time employment during the recession. Part-time workers are less likely to receive health insurance and retirement benefits than are full-time workers, so part-time workers have lower compensation costs. The share of workers who are part-time fell more quickly in the pre-recession period than it has during the recovery, which would suggest slower benefit growth in the recovery. Employers’ average health insurance costs are growing more slowly both because a smaller fraction of workers have employer-provided health insurance and because health care costs are rising more slowly than they did in the past. Based on the 11 microdata from the American Community Survey, the fraction of workers who have employer-provided health insurance declined 4.5 percentage points from 2008 to 2011, with part-time workers experiencing the largest decline. We also know that health care costs, which increased faster than the general rate of inflation for many years, have been growing more slowly. The Bureau of Economic Analysis’s Personal Consumption Expenditure Health Care Price Index shows that during the recovery, health care prices grew about half as fast as before the recession. The decline in compensation costs during the recovery suggests that the two components of the Federal Reserve’s dual mandate are not in conflict at this time. Inflation risk is low, and the labor market is soft enough that firms can hire without having to increase compensation. Federal Reserve Bank of Cleveland, Economic Trends | January 2014 12 Monetary Policy Yield Curve and Predicted GDP Growth, December 2013 Covering November 23, 2013–December 13, 2013 by Joseph G. Haubrich and Sara Millington Overview of the Latest Yield Curve Figures Highlights December November October Three-month Treasury bill rate (percent) 0.07 0.08 0.08 Ten-year Treasury bond rate (percent) 2.86 2.74 2.66 Yield curve slope (basis points) 279 266 258 Prediction for GDP growth (percent) 1.2 1.2 1.2 Probability of recession in one year (percent) 1.50 1.86 2.24 The yield curve became somewhat steeper over the past month, with the three-month (constant maturity) Treasury bill rate dropping to 0.07 percent (for the week ending December 13), just down from November’s 0.08 percent, which was unchanged from October. The ten-year rate (also constant maturity) moved up to 2.86 percent, up from November’s 2.74 percent and a good twenty basis points above October’s 2.66 percent. The slope increased to 279 basis points, up from November’s 266 basis points and from October’s 258 basis points. Sources: Board of Governors of the Federal Reserve System; authors’ calculations. Yield Curve Predicted GDP Growth Percent Predicted GDP growth 4 2 0 -2 Ten-year minus three-month yield spread GDP growth (year-over-year change) -4 -6 2002 2004 2006 2008 2010 2012 2014 Sources: Bureau of Economic Analysis, Board of Governors of the Federal Reserve System, authors’ calculations. Federal Reserve Bank of Cleveland, Economic Trends | January 2014 The steeper slope had a negligible impact on projected future growth. Projecting forward using past values of the spread and GDP growth suggests that real GDP will grow at about a 1.2 percentage rate over the next year, even with November and October’s projections. The influence of the past recession continues to push towards relatively low growth rates. Although the time horizons do not match exactly, the forecast is slightly more pessimistic than some other predictions, but like them, it does show moderate growth for the year. The slope change had only a slight impact on the probability of a recession. Using the yield curve to predict whether or not the economy will be in recession in the future, we estimate that the expected chance of the economy being in a recession next December is 1.50 percent, down from November’s estimate of 1.86 percent, as well as the October estimate of 2.24 percent. So although our approach is somewhat pessimistic with regard to the level of growth over the next year, it is quite optimistic about the recovery continuing. 13 The Yield Curve as a Predictor of Economic Growth Recession Probability from Yield Curve Percent probability, as predicted by a probit model 100 90 Probability of recession 80 70 60 Forecast 50 40 30 20 10 0 1960 1966 1972 1978 1984 1990 1996 2002 2008 2014 Note: Shaded bars indicate recessions. Sources: Bureau of Economic Analysis, Board of Governors of the Federal Reserve System, authors’ calculations. Yield Curve Spread and Real GDP Growth Percent 10 GDP growth (year-over-year change) 8 6 The slope of the yield curve—the difference between the yields on short- and long-term maturity bonds—has achieved some notoriety as a simple forecaster of economic growth. The rule of thumb is that an inverted yield curve (short rates above long rates) indicates a recession in about a year, and yield curve inversions have preceded each of the last seven recessions (as defined by the NBER). One of the recessions predicted by the yield curve was the most recent one. The yield curve inverted in August 2006, a bit more than a year before the current recession started in December 2007. There have been two notable false positives: an inversion in late 1966 and a very flat curve in late 1998. More generally, a flat curve indicates weak growth, and conversely, a steep curve indicates strong growth. One measure of slope—the spread between ten-year Treasury bonds and three-month Treasury bills—bears out this relation, particularly when real GDP growth is lagged a year to line up growth with the spread that predicts it.. Predicting GDP Growth We use past values of the yield spread and GDP growth to project what real GDP will be in the future. We typically calculate and post the prediction for real GDP growth one year forward. Predicting the Probability of Recession 4 2 0 10-year minus three-month yield spread -2 -4 -6 1953 1960 1967 1974 1981 1988 1995 2002 2009 Note: Shaded bars indicate recessions. Source: Bureau of Economic Analysis, Board of Governors of the Federal Reserve System. Federal Reserve Bank of Cleveland, Economic Trends | January 2014 While we can use the yield curve to predict whether future GDP growth will be above or below average, it does not do so well in predicting an actual number, especially in the case of recessions. Alternatively, we can employ features of the yield curve to predict whether or not the economy will be in a recession at a given point in the future. Typically, we calculate and post the probability of recession one year forward. Of course, it might not be advisable to take these numbers quite so literally, for two reasons. First, this probability is itself subject to error, as is the case with all statistical estimates. Second, other researchers have postulated that the underlying 14 Yield Spread and Lagged Real GDP Growth Percent 10 One-year lag of GDP growth (year-over-year change) 8 6 4 2 0 Ten-year minus three-month yield spread -2 -4 -6 1953 1960 1967 1974 1981 1988 1995 2002 2009 determinants of the yield spread today are materially different from the determinants that generated yield spreads during prior decades. Differences could arise from changes in international capital flows and inflation expectations, for example. The bottom line is that yield curves contain important information for business cycle analysis, but, like other indicators, should be interpreted with caution. For more detail on these and other issues related to using the yield curve to predict recessions, see the Commentary “Does the Yield Curve Signal Recession?” Our friends at the Federal Reserve Bank of New York also maintain a website with much useful information on the topic, including their own estimate of recession probabilities. Note: Shaded bars indicate recessions. Sources: Bureau of Economic Analysis, Board of Governors of the Federal Reserve System. Federal Reserve Bank of Cleveland, Economic Trends | January 2014 15 Economic Trends is published by the Research Department of the Federal Reserve Bank of Cleveland. Views stated in Economic Trends are those of individuals in the Research Department and not necessarily those of the Federal Reserve Bank of Cleveland or of the Board of Governors of the Federal Reserve System. Materials may be reprinted provided that the source is credited. 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